The Dismantling of the Economy's Legal Infrastructure

8/14/2019 The Dismantling of the Economy's Legal Infrastructure

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The fin de sicle Dismantling of theEconomys Legal Infrastructure

By Carolyn Sissoko

August 27, 2009


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I Dismantling the Law

One aspect of the recent financial crisis has not received as much attention as it deserves: therecent dismantling of the centuries-old legal structure that governed derivative contracts. Inearly 19th century Britain a derivative contract on railroad stock was legal, whereas the same

contract on Bank of England shares was not. The Gaming Act of 1845 rationalized this situationby voiding all derivative contracts that fell within the definition of a wager. A test commonlyused to determine whether or not a derivative was a wager looked at the intended method ofsettlement: if the derivative was to be settled by delivery of the underlying asset it was not awager, whereas typically derivatives that were settled in cash were wagers. In addition, thecommon law definition of a wager exempted from the Gaming Act any contract where one partycould demonstrate that the contract was being used to hedge genuine economic risk. Similarlegal standards were implemented in the United States. To finesse this legal situation where cashsettled derivatives were void, members of the various Exchanges in both Britain and the USpurchased offsetting contracts and cleared them. By the early 20th century, exchange tradedderivatives were held to be legally enforceable. In both countries, however, derivatives that were

traded over-the-counter, were settled in cash and were not bona fide hedges fell under thejurisdiction of gambling law through most of the 20th century and were void.

These legal norms comprised an important part of the financial infrastructure that underpinnedeconomic growth in Britain and the US from the second half of the 19th century through the lastdecades of the 20th century. The laws affecting financial contracts began to be changed in the1990s and by early in the 21

stcentury, the conscious decision by 19

thcentury legislators and

jurists to void over the counter derivative contracts that did not serve an insurance purpose hadbeen reversed.

This dramatic change in financial law has gone largely unnoticed because of a very recentchange in the way that society thinks about financial contracts. In 19th century Britain the factthat many of the derivative trades that took place on the Stock Exchange were wagers was auniversally accepted truth. By contrast the Wikipedia entry on Gambling states: Somespeculative investment activities are particularly risky, but are still usually considered separatelyfrom gambling and cites securities derivatives, such as options or futures as examples.1

A Brief History of Derivatives Contracts

Contracts for future delivery are probably as old as trade itself.2

Indeed, in communities withlimited access to money, trade typically involved commitments to future transactions.3 Thus, itshould come as no surprise that forward contracts developed simultaneously with commoditymarkets. Once an economy was monetized, cash settlement of the forward contract was a minorinnovation. Stock and bond markets only arise in monetized economies, and the evidence

1 Viewed 1/12/2009.2 Postan in his essay Credit in Medieval Trade (Economic History Review, 1(2) 1928, pp. 243 244) finds thatcontracts for future delievery were common in Medieval Europe. Also see: Ernst Weber, A Short History ofDerivative Security Markets (June 2008). Available at SSRN: http://ssrn.com/abstract=11416893 Legal records from feudal manors in England indicate that there were settlement days, where the previous monthstransactions are formally offset and the balance is settled. Source?


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indicates that cash-settled forward contracts on securities developed more or lesscontemporaneously with the markets themselves.

In short, derivatives are as old as commodity and securities markets. In 16th century Europe theuncertain flow of precious metals from the Americas meant that the finance of international trade

resulted in currency risk. And we find accounts of active markets in currency futures that dateback to 1542.4

The Dutch stock market was founded at the start of the 17th

century andderivative contracts are found in the earliest records of those markets.5 Option contracts (and theleverage they involve) may have played an important part in the Dutch Tulipmania of the 1630s.

6

The first work on speculation and hedging techniques, Confusion de Confusiones, was publishedin 1688 in Amsterdam and described futures, options and trading on margin in detail.7

1688 was also the date of the Glorious Revolution which brought William of Orange and a hostof Dutch financiers to England. By the start of the 18th century London, too, had a flourishingstock exchange, where stocks and government debt both traded and the full range of derivativeswas available. Thus, in England interest rate derivatives date back to the 18

thcentury.

In 18th and 19th century Britain, derivatives were called time bargains or time contracts.8 Theterm time bargain refers to the fact that derivatives are financial contracts, whose valuedepends on the future value of an asset (or other item) that is called the underlying. Thus theterm time bargain distinguishes derivative trades from spot trades that depend only on thecurrent price of the asset.

In England the 1734 Stockjobbing Act prohibited trade in derivatives on securities that were notsettled by delivery of the underlying. In 1766, however, Adam Smith observed that timecontracts on stock were still traded, even though the law gives no redress for failure to pay. Henoted that reputation effects keep the market going: People who game must keep their credit,else nobody will deal with them.9 By 1844 the privately enforced market in derivativescontracts on the British Funds was so successful, that the Select Committee on Gaming decidedthat there was no need for judicial and legal enforcement of speculative derivative contracts atall.

The history of derivatives in the United States follows a similar pattern. In 1792 the New YorkStock Exchange was founded, and by 1829 a Stockjobbing Act was passed to prohibit derivativetrades that were not settled by delivery of the underlying. The Stockjobbing Act was repealed in1858, and by the 1870s there was an active market in stock options with prices quoted in the

4

Cristoval de Villalon (1542) quoted in Weber, op. cit.5 Van Dillen (1935) quoted in Weber, op cit.6 Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,McGraw-Hill Professional, 1999, p. 2-3 and Earl Thompson and Johnathan Treussard, The Tulipmania: Fact orArtifact? UCLA mimeo 2002, http://www.dklevine.com/archive/thompson-tulips.pdf.7 Larry Neal, The Rise of Financial Capitalism, 1990, Cambridge U Press, p. 16. Also see Weber, op cit. p. 15.8Report of the Select Committee on Gaming, House of Commons, 1844. This Committee investigated theconsequences of the Stockjobbing Act of 1734 that explicitly prohibited option contracts and certain forward (orfutures) contracts. The generic term used for these contracts was time bargain or time contract.9 Smith (1766) quoted in Weber op cit. p. 22.


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newspaper.10 This active market disappeared in the late 1870s, a fact that Kairys and Valerio(1997) attempt to explain by claiming that prices disadvantaged investors. It is possible thatthere is a more prosaic explanation for the collapse of the market: cash settled derivativecontracts were held by the courts to be unenforceable contracts under the lawinIrwin v. Williar,which was decided by the Supreme Court in 1884 on the basis of events that took place in 1877.

As in England, however, the legal status of derivatives on securities did not put an end to thetrade in them. In the 1920s option pools, where a group of investors built up a large position inlow-priced call options on a firm often with the help of the company itself or of its officers and then preceded to manipulate the firms share price, were extremely common. For this reasonin the 1930s options were almost outlawed. However, the head of the Put and Call Brokers andDealers Association (PCBDA) convinced Congress that options could be used to transfer risk.Thus the SEC was given jurisdiction over the options industry by the Securities and ExchangeAct of 1934 and the PCBDA became a self-policing entity subject to the SECs authority. Thenext year the Chicago Board of Trade was authorized to establish an options exchange, but it wasonly in 1973 that trade opened on the Chicago Board Option Exchange.

11Prior to the

establishment of the CBOE, option trading on secondary markets was very limited.

While there were active markets in stock options in the 19th

century, they were much morelimited than the option markets with which we are familiar today. Options sold in New York inthe 1870s were American, close to at-the-money and had one month to maturity; in London atthe turn of the century options were European, at-the-money and had one month to maturity.The fact that in or out of the money options were rarely traded is an indicator that secondarymarkets in options were not very deep.

Nowadays options are regularly traded in or out of the money and with more than a year toexpiration. Exchange trading of options facilitates an active secondary market in options,allowing any individual with a brokerage account to be an option trader. Thus while we can beconfident in the knowledge that forward, futures and option contracts on securities have beentraded over the counter since the early days of securities markets, we must also acknowledge thata broader range of products trade on modern derivative markets and that markets are far deeperthan they were in the past.

In fact the last quarter century has seen an unprecedented boom in derivatives contracts and inthe structured products that are based on them. Every major investment bank has a division thatfocuses on structured finance or on the use of derivatives to create new investment products outof old-fashioned debt, equity and money market instruments. Many reasons have been proposedfor this sudden wave of financial innovation including the common use of derivative pricingalgorithms and the growth of computing power that enables traders to use a model to pricecomplex products. I suspect that the reason for this growth is more fundamental: a change in the

10 Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,McGraw-Hill Professional, 1999 documents a call ticket dated 1875. Joseph Kairys and Nicholas Valerio, 1997,The Market for Equity Options in the 1870s,Journal of Finance, 52(4), pp. 1707-23.11 Geoffrey Poitras, 2002,Risk Management, Speculation, and Derivative Securities, Academic Press, pp. 42 46and Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,McGraw-Hill Professional, 1999, pp. 6 9. The CBOE was created as a separate organization so that the CBOTwould not have to answer to two different regulators, the CFTC and the SEC.


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way that society thinks about financial contracts has led to a change in the legal status of over thecounter derivatives contracts.

The changing view of financial contracts

In 19

th

century Britain time bargains were often settled by paying cash rather than actuallytrading the underlying.12

A cash settled derivative contract was called a contract for differenceand was considered a wager.13 Legal records indicate that these contracts were common. Thus,when Englands House of Commons established a Select Committee in 1844 to study the state ofthe law related to gaming, the fact that the wagers being made on the Stock Exchange lay underthe Committees purview was assumed by witnesses and Committee members alike.14 PoliceCommissioner Daniel Harvey when asked about gaming houses in the City of London, responds:As to gambling-houses, in the larger sense of the term, I know of none, except the StockExchange may be so considered. When questioning Mr. John Bush, the Chairman opens with:Have you any knowledge of the system of gambling which is understood to be going on in theStock Exchange? And the Report of the Committee itself explicitly addresses time bargains.

Thus, it was clearly the intent of legislators that the Gaming Act of 1845, which enacted therecommendations of the Committee by voiding all gambling contracts, be applied by jurists totransactions on the Stock Exchange that met the definition of a wager.

15

The same attitude toward speculative financial contracts is found in any of a wide variety ofearly 20th century American legal texts.16 I will cite the text of Mack and Hales Corpus Juris(1922).

17Options and futures contracts are covered in the section titled Gaming. After defining

Futures, the authors note: The term futures has grown out of those purely speculativetransactions, in which there is a nominal contract of sale for future delivery, but where in factnone is ever intended or executed. In the subsection on the validity of gambling transactions,the authors observe: If under the guise of a contract of sale, the real intent of both parties ismerely to speculate in the rise or fall of prices, and the property is not to be delivered, but at thetime fixed for delivery one party is to pay the other the difference between the contract price andthe market price, the whole transaction must be considered as a wager and invalid. The validityof option contracts is also discussed and the same conclusion is reached: if the intent of thecontract is that differences will be paid then the contract is a wager and void.

12 This was also true in 17th century Holland. Archetypically it appears that cash settled derivatives markets almostalways develop alongside stock markets.13 The modern usage of contract for difference refers specifically to a forward contract that is settled in cash.14Report of the Select Committee on Gaming, House of Commons, 1844. See the report itself (p. v) and inparticular the testimony of Police Commissioner Daniel Harvey and Mr. John Bush. Many other witnesses mentionthe Stock Exchange. (The Report has an excellent index.)15

Note that a wager was not formally defined under common law until 1892. In Carlill v. Carbolic Smoke Ball Co.it was determined that a wager involves an agreement between two people that upon the determination of anuncertain event or fact, one shall receive from the other a sum of money or other stake. (The Modern Law ofContract, Richard Stone, Routledge Cavendish, 2005, p. 374.)16 See for exampleJudicial and Statutory Definitions of Words and Phrases, West Publishing Company, 1904, p.5002 orLegal Definitions: A Collection of Words and Phrases as Applied and Defined by the Courts,Lexicographers and Authors of Books on Legal Subjects, Benjamin W. Pope, Callaghan and Co., 1920, p. 1082.17Corpus Juris: Being a Complete and Systematic Statement of the Whole Body of the Law as Embodied in andDeveloped by All Reported Decisions, William Mack and William Benjamin Hale, American Law Book Co., 1922.Quotes from pages 992, 1055 and 1061 respectively.


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Overall the Corpus Juris makes it clear that what distinguishes a valid financial transaction fromone that is void under gambling laws is the intent to deliver the underlying commodity or asset.This standard was established by the US Supreme Court inIrwin v. Williar(1884), where theCourt held that a contract with no intent to deliver is an act of speculation and therefore a wager

under the law.

18

Turn of the century legal scholars drew a clear distinction between investment and speculation.19th century jurists recognized that speculative transactions are zero-sum whatever is gained byone party is lost by the other and thus, by definition, unproductive.

19While speculation was

often tolerated, it was generally considered an activity too trivial to merit the expenditure of acourt of laws time and resources.20 Investment contracts, on the other hand, were viewed asproductive and important elements of a healthy economy. Thus, it was entirely appropriate forthe courts time to be spent adjudicating disputes related to investment.

As noted above, the main criterion used to distinguish a speculative contract from an enforceable

contract was the delivery of the underlying asset. Thus, common law in the 19

th

century set astandard: only financial contracts that were closely tied to transactions in the real economy wereenforceable under the law.

21

By contrast Britains Financial Services Act of 2000 (FSA) defines investment to include awide variety of common investments, futures, options and any right or interest in anythingwhich is an investment.

22Thus, swaps and virtually all other derivatives are considered

investments under British law, because one party always has a right to the income stream froman investment even though tomorrow that right may turn into an obligation. As wasmentioned above, this view of investments has entered into the Wikipedia entry on Gambling.

If Britains Financial Services Act and Wikipedia are representative of the modern understandingof the word investment, thenBlacks Law Dictionary (2004) is out of date. It reads:

Investment. 1. An expenditure to acquire property or assets to produce revenue; a capital outlay.2. The asset acquired or the sum invested.

Under this definition, a derivative contract where there is no expenditure by either party at theoutset cannot be considered an investment. Neither forward contracts, nor swaps meet the termsof the definition, and futures contracts which require only the posting of a small margin whichwill be returned, if the contract does in fact produce revenue instead of expending it probablyarent investments either.

18 Cited in Lynn Stout, Why the law hates speculators,Duke Law Journal, 48(701), pp. 714 715.19 See, for example, the quote from the Supreme Court of Pennsylvania (1867) in Lynn Stout, Why the law hatesspecultators,Duke Law Journal, 48(701), p. 717, n. 57.20Report of the Select Committee on Gaming, House of Commons, 1844, p. vi.21 In this view, the fact that stocks and bonds finance real economic activity directly means that derivativetransactions that settle by delivery of stocks or bonds are closely tied to the real economy.22 Financial Services Act 2000, Schedule 2, Part II.


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It appears that currently the meaning of the word investment is in transition. On the one hand,the traditional meaning, which would probably be acceptable to our 19th century forebears, is stillin use. This traditional definition requires the expenditure of an initial sum in order to receive inexchange a revenue stream.

On the other hand, in certain circumstances a new meaning of the word has developed. Underthe FSAs definition, an investment is not just any financial asset, but can also include financialliabilities. A swap, for example, requires no initial outlay of funds by either party, but typicallybecomes a liability for one party and an asset for the other depending on the behavior of marketprices after the contract is signed. Because from the point of view of one party to the contract, aswap can morph daily from asset to liability and vice versa, considering it an investmentclearly adds a new dimension to the meaning of the word.

Our 19th century forebears would easily have recognized the potential economic role of a swap:when paired with another asset a swap can play the role of insurance. However, in the absenceof such an insurance role, they would never have accepted that a swap was an investment

contract; on the contrary, they would have called it speculation.

In short, in modern usage we find that the distinction between speculation and investment iseroding. For this reason, it is not surprising that the presumption in the 21

stcentury is that

financial contracts are not subject to gambling laws, or that the opposite presumption prevailedin the 19th century.

A brief review of early derivatives law

The regulation of derivatives in Britain started in 1734 when the Stock-jobbing Act explicitlyvoided all option contracts, cash settled forward contracts, short sales and contracts involving ashort forward position. The Act also imposed fines as high as 500 on derivative transactions.While the harsh penalties enacted clearly had the intent of closing down derivatives markets, acentury later juries apparently refused to impose the fines. By the middle of the 19

thcentury the

British market for securities based derivatives had bifurcated: those that referenced newer sharesand foreign stocks were legal contracts, whereas those referencing British government debt andthe oldest names on the stock market were illegal and unenforceable. In 1844 the SelectCommittee on Gaming considered the incoherent state of the law, determined that the informalpenalty of expulsion from the Stock Exchange was sufficient to support a substantial market inderivatives and concluded with a recommendation to void all time bargains that were in factwagers.23 Thus, the Gaming Act of 1845 simplified the legal structure for derivatives by makingall wagers void.

The extra-legal status of many of the trades that took place on the Stock Exchange continued fordecades. For example, after an episode of boom and bust in bank stocks (which coincided withthe failure of several banks) Leemans Act was passed in 1867 with the goal of prohibiting shortsales in bank stocks. The law stated that all bank stock transactions were void, unless thespecific shares traded were identified by registration number or owner. Apparently the members

23Report of the Select Committee on Gaming, House of Commons, 1844. On the derivatives markets supported bythe penalty of expulsion from the Stock Exchange, see in particular questions 866 872 and 2555 2570.


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of the Stock Exchange dealt with this law, just as they had dealt with the Stockjobbing Act acentury earlier: they ignored it. As long as members were trading with each other in bankshares, no problems arose, but at least one court case makes it clear that non-members werewilling to void their obligations on the basis of documents without the legally requiredinformation.24

By 1878, the courts held that the transactions on the Stock Exchange were not settled in cash, butinstead involved the clearing of legal transactions that offset each other.25 Thus transactions onthe Stock Exchange were not voided by the Gaming Act. In a bit of a legal twist, however, in thecase of a bankrupt member of the Stock Exchange the courts also held that the Stock Exchangeassignee who resolved the transactions of the defaulter by taking payment in cash from hisdebtors on the Exchange and allocating proceeds in cash to his creditors on the Exchange had noobligation to turn the proceeds over to a bankruptcy trustee. Effectively the settlement by theStock Exchange of the defaulters transactions did not involve an assignee receiving paymentsthat were debts under the law, but instead the assignee received the payments per the rules of theStock Exchange and thus had to act according to those rules. In short, while Stock Exchange

transactions were not void, they were also not subject to resolution in bankruptcy court.

26

As one might expect, many of the principles that were established under British law were alsoapplied by courts and legislatures in the United States. In general, when the intent of a forward,futures or option contract was to settle by delivery of the underlying asset or to insure againstlosses on an existing position, the contract was valid and, when the intent of the contract was tosettle in cash, the contract was a wager and void.

27

The US treatment of exchanges differed in some respects from that of Britain. When the USSupreme Court recognized the validity of exchange-traded derivatives in 1905, it did so not onlyon the basis that offsetting positions are distinct from cash payment, but also because: It seemsto us an extraordinary and unlikely proposition that the dealings which give its character to thegreat market for future sales in this country are to be regarded as mere wagers.28 This rulingmade possible the passage of bucket shop laws, which criminalized establishments that

24The Law Relating to Betting, Time-bargains and Gaming,George Herbert Stutfield, Waterlow & Sons, 1884, p.99.25 Contracts on the Stock Exchange are never for the receipt or payment of differences. All contracts, etc., arereal transactions for cash or for a day named, contemplating the actual transfer or delivery and which transfer ordelivery can only be rendered unnecessary by a new and equally real bargain on the one part to accept and pay foron the same day, and on the other part to transfer or deliver an equivalent amount of the same stock. It is thenfurther stated that if a member having, say, bought stock which he was unwilling or unable to take up, he balancesthe transaction by selling a similar amount of (but not the identical) stock for the same settling day for which the

bargain was originally made, so as to enable that particular transaction to be written off an balanced.Thacker v.Hardy (1878) as quoted in The Law Relating to Betting, Time-bargains and Gaming, George Herbert Stutfield,Waterlow & Sons, 1884, p. 84.26Ex parte Grant re Plumbly (1880) is explained in The Law Relating to Betting, Time-bargains and Gaming,George Herbert Stutfield, Waterlow & Sons, 1884, p. 78 79. This precedent was first set byNicholson v Goochbefore the repeal of the Stockjobbing Act in 1860. InNicholson v Gooch the courts found that, because most of thebankrupts Stock Exchange transactions were void, his legal creditors had no claim to them.27Anglo-American Securities Regulation: Cultural and Political Roots, 1690-1860,Stuart Banner, CambridgeUniversity Press, 2002, p. 182.28 Cited in Lynn Stout, Why the law hates specultators,Duke Law Journal, 48(701), pp. 720.


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claimed to sell derivatives, but in practice were bookmakers taking bets on the performance ofcompanies and commodities listed on the exchanges. Prior to the formal recognition ofexchange-traded derivative transactions as legal, it was difficult to regulate bucket shops withoutadversely affecting trade on the exchanges as well.

Thus in early 20

th

century America, financial contracts that were directly tied to the realeconomy and contracts that were traded on exchanges were legal. Trade in financial contractsthat did not meet these criteria was unenforceable in a court of law.

The Commodity Exchange Act of 1936 codified this approach to derivatives for a specific groupof commodities. A contract for future delivery is legal if either (i) it is traded on an organizedexchange or (ii) the intent is to settle the contract by transferring the underlying asset. This lawrenders over-the-counter, cash-settled contracts for future delivery illegal.

29

The codification of common law as it applies to derivatives was further advanced by the revisionof the Commodity Exchange Act in 1974. The revised law covers contracts for future delivery

on all goods (except for onions), articles, services, rights and interests, and establishes theCommodity Futures Trading Commission (CFTC) to enforce the law.30

Note that the Commodity Exchange Act regulates all contracts for future delivery. As the termfutures was already in common usage and the law explicitly creates an exception for forwardcontracts settled by delivery of the commodity, it is clear that the intent of the law was to addresstime bargains (or derivative contracts) in general. Up until at least 1987, the General Counseland Commissioners of the CFTC believed that not only futures, but also swaps and options layunder their purview.31 In fact, according to Brooksley Born it was not a legitimate legalposition to claim that the CFTC did not have jurisdiction over over-the-counter derivativemarkets in 1998.32

If (i) the term contracts for future delivery is understood to include all derivatives, includingforward contracts, futures, options, swaps and the hybrid and structured instruments based onthem, and (ii) there is no penalty for trading in over-the-counter, cash-settled derivatives (i.e.they are simply void), then the Commodity Exchange Act of 1974 would serve to reinforce thefundamental principles of law that were derived in the 19

thcentury.

Modern derivatives law

As noted above, in Britain the Financial Services Act establishes an extremely broad definitionof investments: it appears that all over-the-counter, cash-settled derivatives are defined in theFSA to be investments. The FSA also states explicitly that as long as an investment or aninvestment related contract is entered into by one party by way of business, that contract will

29 Lynn Stout, Why the law hates specultators,Duke Law Journal, 48(701), pp. 722 3.30 Lynn Stout, Why the law hates specultators,Duke Law Journal, 48(701), pp. 722 3. An explicit exception ismade for financial securities which are subject to the jurisdiction of the SEC.31 Mark Young and William Stein, 1988, Swap Transactions Under the Commodity Exchange Act: IsCongressional Action Needed? Georgetown Law Journal, 76, pp. 1917 1947.32 Rick Schmitt, Prophet and Loss, Stanford Magazine, March/April 2009,http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html


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not be voided by gambling laws.33 Thus in Britain the Financial Services Act of 2000 dismantlesthe traditional legal approach of treating only derivatives that are closely tied to the real economyas valid contracts.

In the US, the dismantling of the traditional approach to derivatives took place over the last two

decades. In 1992 a law was passed permitting the CFTC to exempt contracts from itsjurisdiction and in 1993 swaps were exempted by the CFTC from the Commodity Exchange Act.In 1998, however, the CFTC put out a Concept Release which raised the possibility that the 1993decision would be reevaluated. The CFTC, however, did not have the support of other financialmarket regulators who instead proposed that the Commodity Exchange Act be rewritten toseverely circumscribe the jurisdiction of the CFTC.34

Thus, in December of 2000 the Commodities Futures Modernization Act was passed as part ofthe 2001 federal budget appropriations. This law removed swaps and hybrid instruments fromthe jurisdiction of the CFTC. Under the Act, transactions between Eligible Contract Participantsare no longer subject to the provisions of the Commodity Exchange Act which voided over-the-

counter, cash-settled contracts for future delivery. It also preempted the application of stategambling and bucket shop laws to over-the-counter derivatives. In short, by makingunenforceable contracts enforceable the Commodity Future Modernization Act of 2000completely changed the legal framework which had shaped the financial system of the UnitedStates for nearly two centuries.

Releasing finance from the constraints of the real economy

19th century legislators and jurists crafted a carefully considered approach to derivatives. Theprinciple underlying this approach was that financial contracts are legally enforceable only whenthey are tied to the real economy. For this reason, if (i) the intent is to deliver the underlyingasset or (ii) the contract insures one party against an existing risk, the contract plays a role indistributing real economic risk and is legally enforceable.35 On the other hand, contracts whereboth parties were speculating on some future event such as the price of an asset wereconsidered wagers and void.

By establishing a clear distinction between speculative derivatives and those that served aneconomic purpose and enforcing only the latter, 19th century jurists created a legal framework inwhich finance was forced to address the needs of the real economy. By contrast in the 21stcentury, the distinction between speculation and investment has eroded. All financial contractsare enforceable, whether or not they contribute to the real economy and finance has been freedfrom the bonds that held it in check for almost two centuries.

33 Financial Services Act 2000, Section 41234 Presidents Working Group on Financial Markets Report, Over-the-counter Derivative Markets and theCommodity Exchange Act, November 199935 The latter is a common law standard. Because derivatives were typically voided under gambling laws, the abilityto demonstrate that the contract indemnified one party against a loss sufficed to prove that the contract was not awager. See also Lynn Stout, Why the law hates speculators,Duke Law Journal, 48(701), pp. 718 9.


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II Early financial history and the development of fiat money

In section one we demonstrate that 19th

century law required financial contracts to serve the realeconomy. Of course, there is a financial history that predates the 19th century. Here, too, wefind that constraints were established to ensure a close tie between the real and the financial.

Constraints on finance prior to the 19th

century

As the middle ages were coming to a close Europe developed a financial instrument called thebill of exchange that was managed by a network of wealthy merchant bankers. In its initial formthe bill of exchange was used to finance international trade between Europes leading cities. Thebill was a short-term debt contract that was payable in a foreign country. Clearing mechanismsenabled trade in these bills to minimize the transport of gold and silver across Europe.

In the sixteenth century the bill of exchange evolved into a very different instrument.Endorsement allowed bills to circulate from hand to hand before being redeemed, and domestic

bills became the norm in highly developed commercial economies. Local bankers managed localnetworks and stood ready to discount bills before they were due. Thus, a tradesman with a localbank account could write a bill in the name of a supplier, who could then choose to hold the bill,endorse the bill over to a creditor of his own or cash it less a discount at the bank. The billwas a form of commercial paper that was endorsable and effectively allowed banks to underwritea system of trade credit for the local community. The result was that trade in urban economiesbegan to take place on the basis of a paper monetary system that was supported by a network ofbanks.

In order for the system to work standards had to be put into place to prevent the local tradesmenfrom writing too many bills. In practice a single principle was used to regulate this creditsystem: A bill was valid only if it was issued in exchange for goods. Bills that were written inthe absence of a real exchange were described as fictitious or accommodation paper. Anytradesman who was caught issuing fictitious bills was considered a fraud and excluded from thefinancial network. Suspicion of such fraud could also derail a tradesmans career.

The principle that bills were valid only when they were issued in exchange for real goods is nowknown as the Real Bills Doctrine. This doctrine was the standard our early modern ancestors putin place to ensure that finance served the needs of trade. It had the advantage of being applied atthe individual level, creating a completely decentralized means by which the issue of financialpaper could be controlled.

Nowadays the real bills doctrine is famous because it played an important part in the debate overmonetary policy that took place in England in the early 19th century. The Currency Schoolargued that the Bank of England should be constrained to issue bank notes in an amount that didnot exceed the amount of gold it held in its vaults, while the Banking School argued that the realbills doctrine was sufficient to control the money supply and that the Bank needed to have theflexibility to issue an indeterminant quantity of bank notes when discounting real bills. Itsworth noting that the real bills doctrine was so fundamental to the 18th and early 19th centuryconcept of financial stability, that no one questioned the necessity of adhering to the doctrine.


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The issue in the debate was whether or not the real bills doctrine alone was sufficient to ensurefinancial stability.

The denouement of this controversy took place when the Bank Charter Act of 1844 was passed.This was effectively a compromise. Only the Bank of England was allowed to issue bank notes

and the Banks issue was fixed by the amount of gold in its vaults; however, the Act was subjectto suspension by executive order. In practice, this meant that the Bank of Englands note issuewas restricted unless economic circumstances required a greater supply of notes. The Act wastemporarily suspended in 1847, 1857 and 1866.

The 19th

century evolution of the financial system

In the meanwhile, the British economy was steadily outgrowing the real bills doctrine itself. Bythe start of the 19th century in England the system of domestic bills had evolved into acceptancefinance. A country tradesman who regularly shipped his wares to a London middleman for salewould draw on his account with the middleman when making purchases in his own local

community. The tradesman would write a bill drawn on the London middleman to pay his localsupplier. The supplier would go ahead and circulate the bill through endorsement. However,until the bill was discounted at the local bank, sent by the banker off to his Londoncorrespondent for settlement and formally accepted by the London middleman as an obligation,there was no certainty under the law that the middleman would pay.36

In short, acceptance finance was a prototype for the checking account system that would developdecades later just like a checking account system it required that (i) bad bills or checks bepassed infrequently and (ii) middlemen or bankers could be relied on to honor their obligations.When one recognizes the sophistication of the financial system in Britain at the turn of the 19

th

century, one begins to understand why Henry Thornton considered the science of credit to bethe fundamental source of British growth at the time.37

Now here is the question: Is the bill drawn by the country tradesman on the London middlemana real bill or a fictitious bill? Assuming they have an ongoing relationship is there anythingwrong with a middleman accepting the bill before he has received a delivery of goods? Is thereanything wrong with a middleman extending an overdraft to a tradesman? It was probablyinevitable that the practice of acceptance finance broke down the cultural barriers that hadsupported the real bills doctrine. Henry Thorntons Paper Creditmakes it clear that by the earlyyears of the 19

thcentury, some British bankers were beginning to realize that a good bill could

be backed by nothing more than an individuals personal credit.

Legal cases demonstrate that the use of accommodation paper was growing and becomingmore acceptable through the first decades of the 19th century.38 The Banking Act of 1844started a different trend: banks that were no longer allowed to issue bank notes found another

36 James Rogers, The Early History of the Law of Bills and Notes, Cambridge University Press, 1995, pp. 113, 171-173, 188-189.37 Henry Thornton,An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802, pp. 175 176.38 James Rogers, The Early History of the Law of Bills and Notes, Cambridge University Press, 1995, chapter 10.


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way to create money, the checking account. These two trends combined to create a newfinancial system centered around banks as the arbiters of credit.

The 19th century witnessed a transition from a decentralized system of paper money that wascontrolled by adherence to the real bills doctrine to a more complex system in which short-term

monetized credit was allocated by banks and an ever growing number of firms had access tolong-term credit markets. As was demonstrated in Chapter 1, the growth of long-term creditmarkets and the derivative markets related to them led to the development of a legal doctrine thatrendered purely speculative transactions invalid under the law.

At the same time a new approach had to be found to control the growth of the new monetarysystem based on checking accounts. The Banking Act of 1844 had been a first effort at directcontrol of the money supply. It was unsuccessful in many ways: In the first quarter century afterit was passed, it had to be suspended three times in order to protect the economy from theravages of liquidity crises. And the growth of checking accounts effectively neutered the Act.

In the meanwhile, however, the Bank of England had a discovered a new tool for controlling themoney supply. In the 18th century the Banks discount rate had remained fixed at 5%. As aconsequence in normal times competing banks took most of the trade, and the Banks discountbusiness was relatively small. In a liquidity crisis, however, the Banks discounts would increaseastronomically for a few days or even weeks only to fall back to normal when the panic hadeased.

In the first half of the 19th century a major concern of the Bank was the maintenance of its goldreserves. Thus, the outflow of gold that was associated with crises and strong demand fordiscounts at the Bank caused concern. It didnt take long for the Directors of the Bank to realizethat by raising the discount rate, they could moderate the outflow of gold.39 In the 1820s BankRate, or the discount rate of the Bank of England, started to be used as a policy tool. By themiddle of the century Bank Rate was the principal policy tool that the Bank used to control theflows of gold to and from the Bank and to moderate the growth of credit and of the moneysupply.

The genesis of fiat money

England developed a paper monetary system in the late 18th century. The monetary system wasnot uniform across the country. In commercial regions a large fraction of the circulatingcurrency took the form of domestic bills. Local bank notes were often an important part of thecurrency too, especially in agricultural districts. Bank of England notes were issued in largedenominations and were important for settling interbank accounts, but circulated very little in thecountryside.

This state of affairs changed dramatically in 1797. The finance of the Napoleonic Wars had putan enormous strain on the financial system and the Bank of England risked running out of gold.

39 In fact, this obvious possibility had been raised in 1802 by Thornton who makes it clear that usury laws interferedwith the operation of this mechanism. Paper Credit, p. 254.


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The solution was the suspension of the convertibility into gold of the Bank of England note.This suspension lasted for almost a quarter of a century.

As the local banking networks had relied through their London correspondents on the goldreserves of the Bank England in order to meet the demands of their own customers, it was no

longer possible for local banks to pay out their notes in gold upon request. To resolve thesettlement problem in the countryside, the Bank of England began to issue notes in smalldenominations making it possible for the local banks to pay out Bank of England notes insteadof gold.

Thus, at the turn of the century the British economy shifted very smoothly from a gold standardto a fiat money standard. During the war the economy experienced a moderate level of inflationwith the result that when the war finally ended in 1815 it was not immediately possible to resumeconvertibility of the Bank of England note into gold at the rate that prevailed in 1797.Policymakers, however, were committed to resumption at the original exchange rate. Thus, inthe years following the Napoleonic Wars the British economy was put through a severe recession

and in 1821 convertibility of the Bank of England note was restored.

Despite the fact that gold was now readily available, country banks continued to settle theirobligations in Bank of England notes with frequency for the simple reason that Bank notes wereaccepted by almost everyone. Bank of England notes displaced gold as a means of settlingtrades, because they were in practice good as gold.

Thus, the foundations of a modern banking system were laid in 19th century Britain. Paper banknotes were universally accepted in final settlement of debt. The banking system offeredchecking accounts to the general public and short-term credit to those that met the criteria of thebankers. And finally the whole system was moderated by the Bank of Englands control over theshort term interest rate on bills discounted at the Bank. The great 20th century innovation wouldbe the shift to a true fiat money standard with no convertibility of bank notes into any kind ofreal asset.

Conclusion

In early modern Europe, the real bills doctrine served as a decentralized means of limiting thegrowth of paper money and of tying credit issued by the financial system to the real economy.However, by the end of the 19

thcentury in Britain, it was common for firms to have access to

long-term, as well as short-term, credit, and the real bills doctrine was out of date. It wasreplaced on the one hand by the use of interest rates as a policy tool to control the money supplyand the issue of short-term credit and, on the other hand, by a legal framework that treated onlyfinancial contracts that were closely tied to the real economy as valid contracts.


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III Hedge funds and the theory of speculation

A hedge fund is an investment company that is not required to register with the SEC under theterms of the Investment Company Act of 1940. In general hedge funds are exempt from both theSecurities and Exchange Act of 1933 and the Investment Company Act due to the private

offering exemption. In the decades following the passage of these Acts, this exemption wasinterpreted strictly: the hedge fund had to disseminate information comparable to SECregistration information to all offerees and the offerees had to be sophisticated enough tounderstand the information.

40

Aggressive lobbying led Congress to amend the SEA in 1980 to create an exemption forofferings to accredited investors. These were defined by the SEC to be individuals with a networth of more than $1 million and many institutional investors. Furthermore as long as theoffering was limited to accredited investors, the strict information requirements established bythe Securities and Exchange Act were dropped. This broadening of the private placementexemption allowed the private placements to grow from $18 billion in 1981 to more than $1

trillion in 2006.

41

In 1996 Congress again amended the SEA to preempt state regulation of hedge funds and justabout any security subject to the jurisdiction of the SEC.

42Hedge fund advisors are also exempt

from the Investment Advisors Act of 1940 because they are held to have only one client, thehedge fund itself.43 Because hedge funds are exempt from the Securities and Exchange Act, theInvestment Company Act, the Investment Advisors Act and almost all other regulation, they cancharge fees as a percentage of profits, and do not face constraints on short-selling or leverage.

In 2003 the SEC reported on the beneficial role of hedge funds in financial markets, finding threeprincipal contributions: (i) the speculative trading positions of hedge funds, because they arebased on extensive research, tend to move prices towards their fundamental values, (ii) byparticipating in derivative markets hedge funds take on financial risk, thereby providing liquidityto these markets and contributing to lower financing costs, and (iii) by using hedges such asderivatives and techniques such as short selling, hedge funds protect themselves against marketrisk and thus are able to offer investors a conservative investment choice that preserves principaland is not highly correlated with the returns of equity and fixed income markets.

44

Of course, in retrospect the last point is amusing. Any industry where it is common to charge 1 2% of assets under management, before calculating the profit based fee is unlikely to be able toafford investing the funds under management in manner that preserves principal. Granted a fewfunds (especially the earliest vintage of hedge funds) might actually have innovative enoughstrategies to reliably protect principal, earn an acceptable return and pay themselves 2% per

40 Roberta Karmel, 2008, Regulation by Exemption: The Changing Definition of an Accredited Investor,Brooklyn Law School Legal Studies Research Papers #102, p. 7.41 Ibid., p. 10 11.42 National Securities Markets Improvement Act43 While the SEC promulgated a new rule redefining the term client in 2004, this rule was struck down by a circuitcourt. Ibid. p. 21.44Implications of the Growth of Hedge Funds, SEC staff report, 2003,http://www.sec.gov/news/studies/hedgefunds0903.pdf


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annum, but there is no theory of investment that indicates that the industry as a whole couldsucceed in levitating returns for any significant period of time. We know now that 2008 was theyear that hedge fund returns fell back down to earth and some might say through the earth.

Hedge Funds and Liquidity

To understand why investment strategies that appear to be based on sound analysis can result indisastrous losses, lets consider a classic arbitrage trade. At times a Treasury bond with 10 yearsto run that has just been issued may be priced with a yield as much as one quarter of a per centless than a Treasury bond with 10 years to run that was issued two decades ago. Because there isno logical explanation for this difference (aside from the fact that it is too small for anyone elseto bother with), an arbitrageur might predict that it will disappear over time and that aprofitable trade will be purchasing the high yield 10 year bond, while short selling the low-yield10 year bond (i.e. borrowing it and selling it, so that you must replace the borrowed bond bypurchasing it in the future). Unfortunately this trade can only earn you one quarter of a percenton your money, which, if your capital is small, may not be sufficient to cover the time and effort

of finding and putting on the trade.

45

In order to earn more from the trade the hedge fund needs to borrow money to invest in the trade.The problem with leveraging small returns is that in order to generate returns that are worthwhilethe leverage ratio needs to be extremely high: in order to generate a 7.5% return with a strategythat pays a quarter of a percent the hedge fund must borrow 30 times as much money as it investsitself. This high degree of leverage has an important drawback: if the assets backing theborrowed money fall by more than 3% in value (in this example the price of the high yield bondswould have to fall and/or that of the low yield would have to rise), the hedge fund is going tohave to find additional cash to back the trade. In short a highly leveraged arbitrage trader needsto be able to predict not only which spreads will converge at some time in the future, but alsothat their path to convergence will not deviate too far from current spreads. If spreads do deviatesignificantly from the prediction, the only thing that can save a highly leveraged trade is accessto a large pool of capital.

Thus, an arbitrage strategy can be followed safely only if the arbitrageur has access to enoughcapital to hold the position even if it moves in the wrong direction. The reason that quarter of aper cent arbitrage opportunities are not rare is that the return is too low to attract unleveragedarbitrageurs. Leveraged arbitrage strategies are much more risky, because if the position movesin the wrong direction and the arbitrageur does not have the capital to meet a margin call, thebroker will go ahead, liquidate the position and realize the losses.

Long Term Capital Management is an example of a hedge fund that managed to lose moneyarbitraging 10 year Treasury bond yields. While leverage is the most fundamental problem withhedge fund arbitrage strategies, another consequence of turning the tiny yields on arbitrage tradesinto substantial returns using leverage is that the arbitrageur has to take large positions in themarkets. Meanwhile, the fact that there is an arbitrage opportunity implies that trading is

45 In theory the proceeds from the short sale would cover the costs of the purchase. However, in practice an investormust post margin with the broker to cover potential losses on the short sale, so in practice profits are indeeddependent on the investors capital.


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somewhat thin on at least one of the markets. In other words, leveraged arbitrageurs build up bigpositions in assets with not-so-liquid markets. One side effect of this process is that, if aleveraged arbitrageur is forced to unwind a position quickly, the arbitrageur is all but guaranteedto affect prices. Not only will the arbitrageur affect prices, but the price movement caused by theunwinding of a position will cause the spread that was predicted to narrow to gap out wider.

That is, when the leveraged arbitrageurs model is correct, the unwind of the arbitrage positionwill cause prices to move away from fundamentals.

As long as every market has only one leveraged arbitrageur, there isnt much reason to expectarbitrage to cause serious price dislocations, because the likelihood that spreads will move in away that will force an unwind of the arbitrage position is low. In practice, however, arbitragestrategies spread with financiers from one firm to another. For this reason, it is common to haveseveral hedge funds pursuing the same leveraged arbitrage strategy in the same markets. Whenthere are multiple leveraged arbitrageurs trading in the same markets, things can get verycomplicated.46

InDemon of Our Own Design Richard Bookstaber proposes that the fundamental cause of thecollapse of Long Term Capital Management (LTCM) was Citigroups decision to dissolveSalomons in-house arbitrage group. Salomon, LTCM and a few smaller hedge funds werefrequently arbitraging the same markets. Thus, the dissolution of Salomons trades moved manyof LTCMs spread trades in the wrong direction at the same time. When this effect wascompounded by Russias default, LTCM faced margin calls that it could only meet by selling outof its positions. Unfortunately selling just pushed prices in the wrong direction and led to newmargin calls. During this episode, the spread between low yield and high yield 10 year Treasurybonds approached half of one percent.

In short, the positions LTCM had taken were so large relative to the markets that once it ran outof cash to meet margin calls, nothing could save it. In the end, LTCMs investment bank brokerswere so worried about the losses they would suffer if LTCM continued to unwind its trades thatthey jointly bailed LTCM out LTCM got the massive capital injection it needed to hold on toits trades, but only after ceding supervisory control of the fund to the investment banks.

The economic case for speculation

In light of the LTCM example the SECs claim that the speculative trades used by hedge fundsmove prices towards their fundamental values and increase liquidity in markets by transferringrisk seems simplistic. Leveraged hedge funds take such big positions in markets that thereappear to be situations where hedge funds both distort prices and reduce liquidity in thosemarkets.

Why would the SEC make these claims more than five years after the LTCM collapse? Perhapsbecause moving prices towards fundamentals and providing liquidity by taking on financial risk

46 In The Basis Monster that Ate Wall Street the DE Shaw Group explain how the positioning of levered playerscan affect market prices and, in particular, relate this phenomenon to the 2008 crisis. Seehttp://www.purearb.com/purearb/wp-content/uploads/2009/03/desco_market_insights_vol_1_no_1_20090313.pdf.


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are the principal arguments used to defend the economic value of speculation. Possibly the SECbelieved that, despite practical evidence to the contrary, there was support in economic theory forthese views. Unfortunately the theoretic case in support of speculation is not strong.

The argument that speculation is valuable, because it moves prices closer to fundamentals does

not appear to be founded on economic analysis. On the one hand, as an empirical matter it is farfrom clear how one would go about establishing whether or not speculation moves prices closerto fundamentals and, on the other hand, even if we assume that speculation moves prices in theright direction, there is little reason to believe that these price movements have economicbenefits.

First of all, in the vast majority of real world cases one cannot know whether any given pricemovement or sequence of price movements is towards fundamental value or away from it. Thefundamental value of an asset is an ideal that can be modeled and approximated, but almostnever pinpointed with precision. While it is entirely possible that many speculative trades moveprices towards fundamental value, it is also possible that prices move in the other direction

particularly if the speculators model is wrong. One cant even be sure that speculators whomove prices away from fundamental value will lose money even this proposition depends onassumptions about the path of price movements that are very difficult to verify.

47In short, the

general claim that speculators move prices toward their fundamental values is a modelingassumption that cannot be established empirically, because the fundamental values themselvesare unknown.48

Secondly, even if speculation brings prices closer to fundamental values, economic analysis doesnot support the view that such price movements have economic benefits. The reason for this issimple: the standard models that economists use to discuss social welfare are built on theassumption that prices reflect fundamentals perfectly. In order to consider the possibility that achange in price brings the price closer to the underlying fundamental price, you have to relax thisassumption. Once you remove the assumption that prices reflect fundamentals, you are in anenvironment where an optimal solution is impossible and you are forced to rank sub-optimalsolutions. Unfortunately in a model with two (or more) types of people, most close-to-optimalprice changes will benefit one group at the expense of another and unless one chooses to focuson the welfare of a favored group, it is very difficult to rank equilibria. This challenge ispresumably one of the reasons that Grossman and Stiglitz in their seminal article on the role ofprofitable arbitrage in price formation promised a welfare analysis that was never forthcoming.49

In the real world, speculation moves prices from one imperfect price to another, arguably less-imperfect, price. However, whether or not this change in prices is welfare improving for societyas a whole will depend on a variety of factors one of these is the degree to which speculatorsare able to capture for themselves any social gains that accrue to the improvement in prices. Asimple case in which this would be socially optimal is if we assume that everyones welfare

47 The fact that its not too hard to make money trading volatility is evidence of this.48 This general statement is not disproven by the few true arbitrage trades that do take place such as almostidentical bonds that trade at different prices.49 Sanford Grossman and Joseph Stiglitz, 1980, On the Impossibility of Informationally Efficient Markets,American Economic Review, 70(3), pp. 393 408.


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increases linearly in dollars so that giving a rich person a dollar has the same effect on socialwelfare as giving a poor person a dollar: this is simple to analyze because the distribution ofdollars doesnt matter, just the number of dollars that the economy generates. Of course, someeconomists will argue that this easy-to-analyze framework violates one of the most fundamentalaxioms of economics, that for every individual each additional dollar is just a little less valuable

than the last one. Hopefully, youre now beginning to understand why economists often avoiddiscussing welfare when they cant assume perfectly informative prices.

Given the difficulties intrinsic to analyzing a process of price formation and the need to rank sub-optimal solutions, it is not surprising that the academic literature on price formation reaches noconsensus whatsoever about welfare effects. Some examples: Spiegel and Subrahmanyamdevelop a model where an increase in the number of speculative arbitrageurs may reduce marketliquidity and decrease the welfare of those who need to hedge economic risk.

50By contrast

Bernhardt et al. find circumstances where it is possible for insider trading to reveal enoughinformation via prices to uninformed investors to make them better off and improve theaggregate welfare of all agents.

51In an environment where the profits of speculators with an

information advantage come at the expense of other traders, Dow and Gorton find that whentrading by such speculators is profitable, the aggregate welfare of all agents is lower.52 Welfareanalysis in an environment with inaccurate prices is such a complex problem that Dow and Rahifind that imposing a tax on speculators may make not just society, but the speculatorsthemselves, better off.53

Let me make this point more simply: Adam Smiths invisible hand assumes that pricesaccurately reflect costs and benefits. Once we start to focus, not the on the approximate accuracyof prices, but on their inaccuracy, there is no longer any reason to believe that self-interestedbehavior promotes the welfare of society as a whole.

Thus, when studying price formation, economists find themselves working with models thatoften give counter-intuitive results. And it remains a bit of a mystery why the staff at the SECsimply assumed that moving prices closer to their fundamentals has some intrinsic social value.This would only be the case if there were some empirical evidence that the investing publicbenefits from the price movement. In circumstances where the value gained from the pricemovement accrues to the hedge funds themselves or where the price movement facilitates atransfer of value from the public to the hedge funds, moving prices closer to their fundamentalsmay not be in the interests of the investing public.

To summarize, the appropriate responses to anyone who claims that speculators act to moveprices closer to their fundamental values are: How do you know this to be true? And even if it istrue, so what? Even if the actions of speculators result in more accurate prices, this does notconstitute an argument against restricting the activities of speculators or regulating them.

50 Matthew Spiegel and Avanidhar Subrahmanyam, 1992, Informed Speculation and Hedging in a NoncompetitiveSecurities Market,Review of Financial Studies, 5(2), pp. 307 329.51 Dan Bernhardt, Burton Hollifield and Eric Hughson, 1995, Investment and Insider Trading,Review of FinancialStudies, 8(2), pp. 501 543.52 James Dow and Gary Gorton, 1993, Profitable Informed Trading in a Simple General Equilibrium Model ofAsset Pricing, Rodney White Center for Financial Research Working Paper, 5-93.53 James Dow and Rohit Rahi, Should Speculators be Taxed? 2000,Journal of Business, 73(1), pp. 83 107.


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The more substantial argument in support of speculation is that speculators provide a service tomarkets by taking on risk that other economic actors would prefer not to bear. This view ofspeculators dates back at least to Keynes and Hicks.54 Here, I think it is important to distinguishbetween speculators and speculative trades. When speculators protect others in the economy

from potential losses, they are unarguably providing an important economic service. For thisreason, since the 19th

century the law has distinguished between transactions that indemnify oneparty against losses and transactions where both parties are speculating.55 In short, indemnitycontracts are, by definition, not speculative (or wagering) contracts and cannot be voided bygambling laws.

The argument that speculators play an important role in bearing economic risk is only valid inreference to indemnity transactions. By contrast, if the transaction is speculative or if twospeculators are trading with each other neither party enters the trade for the purpose ofprotecting against existing economic risk, and it is hard to argue that the trade provides a serviceto the real economy.

When proponents of financial deregulation argue that speculative financial transactions shouldnot be outlawed or otherwise circumscribed because these transactions play an important role inrisk transfer, they are creating confusion where there does not need to be any. As a simplematter of definition a financial transaction that transfers an existing economic risk is not aspeculative transaction. The apparent reason for confusing indemnity transactions withspeculative transactions is to create a smokescreen behind which speculative transactions canhide.

In short, regulations which are designed to limit over-the-counter speculative transactions, suchas the Commodities Exchange Act, include exceptions that allow for over-the-countertransactions that have as their purpose the transfer of underlying economic risk.56 There is nocontroversy here. Everyone can agree that any law that limits speculative transactions needs tobe carefully written to permit financial contracts that transfer genuine economic risk exposures.

To sum up, the arguments in favor of speculation are extremely misleading. While it is possiblethat speculation moves prices towards their fundamental values, there is no reason to believe thatthe investing public benefits when such movements take place. Furthermore, the view thatspeculators play an important role in bearing economic risk is irrelevant, precisely because lawsthat limit speculation have exceptions that allow for genuine transfers of risk. In addition, asdemonstrated by the LTCM collapse, in the real world speculative arbitrage often requiresleverage, and when something goes wrong with the leveraged trade, forced selling by speculatorscan disrupt markets, driving prices away from fundamental values and draining liquidity frommarkets.

54 Jack Hirshleifer, 1977, The theory of speculation under alternative regimes of markets,Journal of Finance,32(4), p. 975.55 Lynn Stout, Why the law hates speculators,Duke Law Journal, 48(701), pp. 718 9.56 See, for example, the forward contract exclusion to the Commodity Exchange Act.


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An analysis of the costs and benefits of unenforceable speculative contracts

In chapter one, we found that in the Anglo-American legal tradition speculative financialtransactions are void under gambling laws. Thus one can enter into a speculative contract, butthe judicial system will not enforce the terms of the contract. This may be the best way to

promote efficient speculation.

Consider the properties of a contract between two speculators: First of all, since both parties arespeculators trying to take advantage of (opposite) expectations of price movements, the contractis not part of the economys production process. Secondly, since the contract is not productive,it is zero-sum, whatever one party loses the other gains. Finally, because the contract does notinvolve production and is zero sum (and as argued above there is no social benefit to pricemovements), it lacks externalities the only parties with an interest in the outcome of thecontract are the two parties involved.

The particular character of speculative contracts that they are of interest only to the two parties

involved and neither contribute to, nor detract from, society means that social welfare is bestserved by not enforcing these contracts. To understand this, one need only consider the costs ofenforcing contracts.

If speculative contracts are legally enforceable, any time spent by a judge or other member of thejudicial system on issues related to a speculative contract is a net loss to society, for the simplereason that there is no social purpose that can be served by enforcing the contract. Furthermore,when speculative financial contracts are enforceable, it becomes necessary to determine who iscapable of understanding the risks involved in the contract and thus who is qualified tospeculate.

57Once more we find that the time of regulators and judges will be spent making

determinations that can generate no social value. In short, the problem with making speculativecontracts enforceable is that the enforcement of such contracts necessarily results in a net loss tosociety.

The alternative is to allow speculators to enter into contracts that will not be enforced by thelegal system. When contracts are unenforceable, the appropriateness of a counterparty isdetermined after the fact by the counterpartys decision to pay (or not pay) the debt. This state ofaffairs guarantees careful assessment of counterparties including capacity to pay,understanding of risks and obligations and willingness to pay. Thus the problem of determiningwho is qualified to speculate is now solved, because the speculators will bear the costs ofscreening their counterparties carefully. Effectively we can expect that the Coase theorem willcome into play here: When the speculators costs of finding a reliable counterparty are coveredby the expected gains from the trade, the trade will take place, and when the costs are notcovered, the trade will not take place.

57 The same 1992 law that allowed the CFTC to exempt contracts from the Commodity Exchange Acts jurisdiction,also established a rule that all exempted transactions be solely between appropriate persons. (The term now in useis eligible contract participants.) Thus, the 1992 act changed the focus of the law from the nature of thetransaction to the nature of the participants. Instead of the self-enforcing traditional environment, legal changessince the 1990s have forced the courts to determine whether contract participants had the capacity to understand therisks they were undertaking when it is highly likely that the judges and the jurors themselves do not have a strongunderstanding of the financial contracts in question.


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If speculative contracts are made unenforceable, they will not disappear, but they will becomemuch more rare. The reason for this is simple: Currently the costs of enforcing these contractsare born by society, even though society does not benefit from them. When those who maybenefit from the contract are forced to bear the costs of enforcing the contract, they are sure to

find that only a limited set of contracts has expected returns sufficient to cover the costs. Thefact that unenforceable speculative contracts traded regularly in the 19th

century providesempirical evidence that speculative trades are unlikely to disappear.

In short, our 19th

century forebears arrived at an economically efficient solution to the problemof speculative contracts: void them. Because society cannot gain from them, it is foolish towaste the resources of the judiciary or regulators on them. On the other hand, society does notlose from them either, so there is no need to render them illegal the solution is to render themnull under the law.

This approach leaves open the possibility that someone can demonstrate the economic value of a

specific category of speculative contracts. In this case the contracts in question should be madeenforceable under the law which is effectively what happened over the course of the 19thcentury with exchange traded derivatives contracts. On futures exchanges, for example, a veryliquid market in speculative transactions helps support the contracts that actually serve to transferrisk. Note that this is only true when speculators are monitored to ensure that they do not takepositions large enough to manipulate prices on the underlying market. Thus, exchanges are anexample where the benefits of speculation depend crucially on regulation.

Hedge funds and the economic benefits of voiding speculative transactions

The LTCM experience indicates that the benefits of hedge funds may also depend crucially onthe ability of regulators to monitor them. Hedge funds can be important players providingliquidity to certain markets (i.e. as speculators taking on risk that others dont want) and thosethat focus on arbitrage strategies can be described as leveraged liquidity providers. They are insome ways like banks: their ratio of debt to equity is high, they take on risk that others dontwant to bear, and because their debt is callable, they are unstable institutions. There are howeverimportant differences: a hedge funds capital base can be withdrawn in a matter months, andbecause they are unregulated, hedge funds face no capital requirements at all. Furthermore,hedge funds do not have access to a lender of last resort.

Thus when considering the costs and benefits of hedge funds, one must ask: What services dohedge funds provide that banks do not? And why do banks not provide these services inparticular do the capital constraints that are imposed on banks make these services uneconomic?For example, because banks aim to maintain an asset to capital ratio near 5%, banks will notfollow an arbitrage strategy that is only profitable if leveraged 30 times. When lowcapitalization is the only reason that hedge funds can provide liquidity services to the market,regulators need to closely consider the possibility that the instability associated with highleverage levels may offset any gains from increased liquidity in the market.


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There are a variety of ways to control the instability associated with hedge funds. The amount ofleverage available through their brokers may be limited. Or they may be subject to capitalrequirements. Or the sizes of the positions they take relative to the markets in which they trademay be limited to ensure that the price effect of a hedge fund liquidation is never large.

Observe also that by making speculative trades unenforceable, leveraged hedge funds will beforced to bear risk for the real economy (since no bank will lend against unenforceablecontracts). Thus a policy of voiding speculative transactions will generate large economicbenefits by encouraging speculators to support the real economy rather than to simply tradeamongst themselves. On the other hand, unleveraged hedge funds can speculate as creatively asthey want they just have to make sure their counterparties are willing and able to pay up.


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IV Summary of the benefits of a return to the Anglo-American legal tradition

From the earliest days of financial development, norms were established that constrainedfinancial contracts to meet the needs of the real economy, because from the earliest days it wasnecessary to prevent merchants from issuing too many paper debts. By the 18th century the

principal constraint on the paper monetary system was known as the real bills doctrine.

In the 19th century Britain outgrew this system of financial control, developing long term creditmarkets together with a monetary system based on checking accounts and bank allocated credit.Laws and judicial decisions constrained British credit markets by treating only those contractsthat were closely tied to the real economy as valid. At the same time money and short-termcredit markets were restrained by the Bank of Englands use of Bank Rate.

These financial tools remained in force in both Britain and the United States throughout most ofthe 20th century. By the 1990s, however, with financial crises a distant memory, the distinctionbetween speculation and investment that underlay 19

thcentury financial law was beginning to

erode. Gambling seemed too low a term to apply to high finance and there was a sense that thelaw was out of date. In this environment, contracts that in the past were treated as wagersbecame enforceable. When regulators questioned the changing legal infrastructure, new lawswere passed to definitively liberate speculative contracts from the constraints of the past.

The question, of course, is whether this rewriting of the legal infrastructure supporting ourfinancial system was a good idea. When a transaction is speculative for both parties, it does notaffect the real economy and thus is a matter of indifference to society as a whole. For thisreason, the resources of the judicial system are wasted when they are spent adjudicatingspeculative transactions. On the other hand, when speculative transactions are void under thelaw, participants will have to vet their counterparties carefully to ensure that they understand thetransaction and are willing to make payment. By forcing the participants in the speculativetransaction to bear the costs of monitoring counterparties, the traditional legal structure promotesefficient speculation.

Our financial system and the real economy that depends on it would be well served by a return tothe legal structure that supported 19

thand 20

thcentury growth by making only those contracts

that supported real economic activity legally enforceable. Purely speculative transactions wouldbe legal, but unenforceable and thus ineligible as collateral for a loan. Hedge funds and otherfinancial market participants would only be able to leverage transactions that were closely tied tothe real economy.

The principle that financial markets exist to support the real economy is fundamental. Animportant function of the legal system is to promote this principle by invalidating financialcontracts that are purely speculative. Our forebears understood this. We unfortunately have hadto relearn ancient lessons the hard way.

Documents

The Dismantling of the Economy's Legal Infrastructure