|"Wall Street likes to characterize the proliferation of frenzied financial games as a sophisticated pro-social activity,
facilitating the fine-tuning of a complex economy. But the truth is otherwise. Short-term transactions frequently
act as an invisible foot, kicking society in the shin."
-- Warren Buffett, quoted in an article by William Hanley in Canada's National Post of 100821
In today’s unbalanced economies and fierce international competition, conventional wisdom is that
now is not a good time to introduce a new tax. If something dysfunctional is occurring, the
conventional wisdom -- until the last few months, when economists have begun reviewing what they
have been taking for granted -- has been either to ban it entirely or to let the market drive the offenders
But what if a well-targeted tax were to diminish the rewards of perpetrators from continuing their
dysfunctionality? What if empirical research shows, as research by IMF Visiting Professor Stephan
Schulmeister does show, that the FTT proposed by many G20 national leaders, would both "dampen the
volatility of asset prices over the short run and the magnitude of the swings over the longer run"? What if a smart
version of the FTT, the dsFCF, would make long-term sense in the context of urgently needed financial
reform in the economies with the biggest capital flows, either in or out? And what if implementation of
a modest version of it would immediately augment a country's international reputation as an attractive
place for investors to park capital and also make regulation of a clearly problematic segment of the
activity of the financial sector more cost-effective? What then?
Excessive activity in speculative contracts such as derivatives and assemblies of mortgages has
frequently been fingered as the major accountability of the financial sector in giving rise to the Great
Recession from which we are all now obliged to dig out. The credit crisis which, to the majority of
pundits, began to appear before the end of 2007 and climaxed with the bankruptcy of Lehman, had
been building for a decade, not for a short period. During this building period there were some
experts -- notably Brooksley Born, who briefly headed the Federal agency mandated to oversee
derivative contracts and who felt strongly that the Greenspan-Rubin-Summers laisser-faire approach to
regulating derivative markets was bound to result in a big crash -- who were pointing this out. And the
number of pundits who agreed with her slowly increased in the ensuing years until there was
bipartisan agreement for the bailout of AIG, the world's biggest derivative insurer, and other financial
institutions involved in the same controversial field, in the Fall of 2008.
In this context, is it relevant to keep in mind that AIG had been doing its derivative business under the
Treasury watch of Henry Paulson, who had been head of Goldman Sachs, the Wall Street
headquartered firm that had written the lion's share of outstanding derivative contracts? I don't know:
the issues of accountability are complex. But it is relevant to keep in mind that Henry Paulson's public
opinion on this very critical issue actually changed during his term as Treasury Secretary, a
development for which he deserves credit for a level of honesty that appears to have been unusual
among public figures in the United States in that period.
Given that data from history, growth in unconventional financial contracts must surely have been a
factor in triggering the credit crisis in ways not publicly discussed in simplistically popular media, but
which nevertheless were sensed by people with insight into the field -- as distinct from merely word-
based, i.e. logical, knowledge. Let us therefore put ourselves in imagination into the shoes of people
making a living in the various kinds of occupations that design, promote, rate, insure, make markets
for, trade, and have responsibility for regulating, derivative and other complex financial contracts. And
it then becomes obvious that many in such occupations, must have been participating in a sort of
roulette game with future titles to the variegated currency exchange, real goods, real estate, and
securities orders that constitute such contracts. In other words many were oblivious to the changing
needs of the principals in need of firm future prices around which to optimize the extraction, refining,
processing, manufacturing, distribution, retailing, non-financial service, and event staging activities --
activities that constitute the real sectors of the economy. Although such people might well be skilled in
gleaning rumours about such realities or in understanding the mathematical trending models in books
written about such realities at some time in the past, their current knowledge was not personally
authentic. They were, in effect, letting people outside their professional circle believe otherwise, and
thus were recklessly facilitating, or at least permitting the danger of an eruption of, a credit crisis to
If we then ask ourselves who actually contributes insight to the changing of the prices of derivative and
other unconventional contracts, the answer is clearly not those whose inputs are limited to rumours
and the outputs of never fully accurate mathematical models. Yet, with the advent of high-frequency
trading, approximately half of all the volume of derivative trading is executed on the orders of people
whose knowledge is limited to such rumours and models -- knowledge that clearly lacks authenticity.
Today, such people are combining one or more of the roles of promoters, market makers, dealers,
raters, and traders of exotic contracts, and thus playing roles ethically difficult to reconcile. But they
also appear now to be engrossed in fending off the prying eyes of regulators, politicians, investors,
media and, in extreme cases, prosecutors -- to the outrage of voters around the world. It’s a game no
one seems clearly to be winning -- yet. Not only are the players under scrutiny. The regulators,
including politicians and industry watchdogs as regulators, aren’t getting many plaudits either for
bringing about what we ultimately all need.
So what is it that we all need? In my opinion it is success in ending the ignorances and feints,
pretences, distractions, and ultimately, dishonesties that everyone knows are still, over three years
since most pundits knew a crash was inevitable, occurring in the financial sector.
Moreover, if the financial sector, reckoned to include its political lobbyists and industry watchdogs, is
sucking ever more out of the whole economy, what’s happening to the remainder? It’s getting
squeezed, of course -- as John Cassidy's easy-to-read and entertaining article "What Good Is Wall Street?"
in the New Yorker magazine of November 29, 2010, makes clear. And that’s also worrying and not only
because for many of us the squeeze is too close to home. It’s also dividing us into “bravadoic over-fed
banksters” and “angry under-fed real people” and exacerbating social strife all around the world.
Even worse, it’s making our transition as a human species to a truly sustainable economy – one that’s
fair, organically green, and thus able continually to change and prosper without preventable
catastrophes – even more challenging. Because what each of us wants to know about his or her little
corner of the economy won’t stay still long enough for us to see it for what it truly is and get others to
agree, somewhat at least, on our observations.
OK, we need to do something. So what’s all this about a new tax making sense if only political and
financial leaders would wipe the windshields of their stretch Lincolns and Bentleys?
Financial Derivative Contracts (FDCs), which in this paper includes all financial contracts that do not
document a transfer of current title to a real economy good/service, are designed either to facilitate
capital being matched to talent, labour, and leadership in order to meet real human needs, or only to
make money for the promoting party. Money, of course, is a potential good; but as we have seen a lot
of recently, its spending isn’t always done wisely.
FDCs form the legal links in a series of variously timed, overlapping cycles mediated by their market
makers. Up to a little before the time of the failure of Lehman the global total of outstanding FDCs was
growing much faster than World GDP. Although evaluation of the systemic risk posed by FDCs being
an increasing proportion of bank assets was only beginning to be a discipline, it was probably the
consequence of an economic principle that, articulated perhaps most influentially by former Federal
Reserve Chairman Alan Greenspan to the US Senate Banking Committee in 2003, sounded logical
enough to most to permit such a trend to reach the point where FDCs outstanding amounted, at the
AIG bailout and Lehman collapse, to about 11 times World GDP:
“What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful
vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so."
Some of the financial activity supporting the growth in unconventional financial contracts outstanding
of approximately 2,000% in the decade before the AIG bailout is driven by real needs in the economy.
But a large portion appears to be driven more by the habituated beliefs of “players” whose motivation
appears to be to use money or credit for the sole purpose of making money (a disease known in
Ancient Greek as "Chremastasis") rather than for hearing, feeling, and helping to identify and meet the
true needs of the millions of people who, despite the boom years of the 2000s, have sunk back into
desperate, and therefore potentially violent, straits. To scope out this issue, I asked John Fullerton,
Founder and President of The Capital Institute, and in the late 90s the JP Morgan member of the
Oversight Committee for the dissolution of Long Term Capital Management, to estimate the shares of
the major functional segments of FDC transactions. He replied:
"Perhaps 1-6% is clearly serving real economy needs. Perhaps 20-60% is wanted for market-making directly
supportive of real-economy needs, and so the remainder (34-79%) is only serving the desires of people whose capital
flows are purely speculative, i.e. cannot truly be called investments in the real economy".
Everyone agrees that purely speculative capital flows can be highly disruptive to the best and most
nobly practical plans. This is not to say that some disruptions brought about by responsibly intended
and openly declared derivative strategies are not necessary in transitions known to economists as
creative destructions that turf incompetent or corrupt managers out of office. But it is to emphasize
that by the time of the AIG bailout the overall role of speculative flows was very much more disruptive
than virtually everyone in retrospect would agree was tolerable, let alone optimal. It therefore seems
to me to be rational to envision, and to try to bring about, a global financial future in which the mix of
the three major functional segments described by Mr. Fullerton trace out a path such as that illustrated
in the chart below:
The chart is only conceptual, of course, but its segmentation reminds us that a distinction, one crucial
to the goal of lessening unacceptable financial instability can be made amongst derivative transactions.
Some are more or less tied to real economy needs, i.e. clearly functional for the economy as a whole;
but others are purely speculative, even predatory, i.e. potentially seriously dysfunctional for a
dynamically inter-relating economy as a whole in that they are "injecting dangerous bubbles of future
instability" into financial asset pricing. Their inevitable bursting is easily foreseeable by professional
insiders but less likely to be recognized by investors outside the "inner circle of derivative wise guys".
Let's look at that word "dysfunctional" a little more closely. I see this word as validly applicable to
derivatives in two sets of circumstances.
One circumstance is illustrated by the speculative activity that led to such "crazy" price volatility as we
saw in North American retail markets in the summer of 2009 in oil products. Granted, there were huge
effects of the credit crisis on crude oil prices before and after this period. If it was not actively
dysfunctional in exacerbating necessary price changes, was it as functional, productive, and healthy for
the economy as a whole as such a vast amount of capital as was absorbed in that speculative activity
might have been had it been productively employed from the point of view of the economy as a
whole? The overall function in an economy of derivative trading is not to create money for a rent-
seeking financial sector. It is to smooth necessary adjustments in future prices, including the price of
capital, so that extraction, production, distribution, and cultural event staging plans can be optimized
by competent real-economy principals.
The other circumstance is illustrated by increasingly crazy assumptions of never-ending increases in
the prices of real commodities, including real estate – a mania that in the housing booms presented
market-makers having a more realistic view of its approaching end with a conflict of interest. Those
assumptions and indulgences in conflicts of interest were certainly both dysfunctional in that the
assumptions fed pricing bubbles and the indulgences facilitated it. But whether the bubbles arose
from foolish assumptions or from disgraceful dishonesties, both types of bubble were bound, sooner or
later, to burst.
IF, therefore, derivative contracts can rationally be identified – prospectively, from the perspective of
the economy as a whole, as either very likely to be dysfunctional or otherwise, then a charge levied at
the writing or exchange of a very-likely-to-be-dysfunctional derivative contract would usefully
inhibit dysfunctional trading without throwing the "clean derivative babies out with the dirty bath
water of dysfunctional derivatives".
But is such a prospective differentiation between functional and dysfunctional derivative market flows
both rationally and practically possible? Many say not. Yet if one makes a close examination of the
two poles in the spectrum of risk entailed in different types of derivative contracts, one learns
otherwise -- as did George Soros, at one time one of the most successful speculators of all time, and
now a generally steadfast and insightful philanthropist.
One of the poles of risk is formed by derivative contracts that shift prices at a rate that correlates with
the time horizon needed for intelligent planning of the supply of the real "good" at pricing issue. Such
derivative contracts provide the utility to extraction, refining, production, manufacturing, distribution,
and event planning of an active market for genuine hedging of uncertain future prices, and are
therefore functional contributions to the economy as a whole.
The other pole is formed by speculative contracts that, in contrast, change prices primarily because
traders and market-makers desire, even imagine they need, to trade (and think they can either make a
"killing" or be bailed out when they make monstrous knaves of themselves!), or the institutions
sponsoring them must, to escape from shouldering the consequences of prior improvidently taken
speculative positions, have contracted. Such speculation is oblivious to the reality that good quality
planning by competent real-economy actors is rendered futile by the risk of disappearance of
institutions such as Lehman and AIG or by wild price volatility such as occurred in crude oil futures
over the summer of 2009 or by the flash NYSE market crash of May 2010. Nor does it supply capital to
a market in crisis for, as Mr. Fullerton elaborates in his paper on the subject, it's never there when it's
So we have two poles, and a spectrum between them that looks like this:
. .('bad'/dysfunctional) ... speculation >>>>>>>>>>>>>>>>>>> investment ... ('good'/functional)
The fact that the spectrum of different speculative contracts has this bi-polarity offers a means to
distinguish the "functional" derivative action from the "dysfunctional", using the word "functional" to
mean from the point of view of the general public, or of the economy as a whole. This is because, in
general, the lengths of contracts that have effects more of the first character described above, i.e. are
functional for the economy as a whole, are different from the lengths of contract sought by financial
intermediaries motivated strictly, without regard to the risks such contracts pose to a reasonably stable
evolution of the economy as a whole, by desires to make money in derivative markets.
Therefore a charge on derivative contracts (changes in position) that are deemed, and we'll discuss this
term in detail later in this paper, to be of the second character, i.e. dysfunctional, would render them
prospectively less profitable. That would not only inhibit them but also be consistent with the mixed-
economy free-market principles with which most people are philosophically and practically
In sum, a charge on contracts identifiable prospectively as inordinately risk-laden, and we'll discuss
that term also later in this paper, would diminish the incidence of the price volatility that renders
intelligent planning of extraction, production, distribution, or event scheduling activities futile.
Without inhibiting trading in functional derivatives, a charge on contracts deemed (on which more
below) likely to be of zero or negative functional contribution to the real economy would have the net
effect of diminishing the phenomenon of high-frequency trading -- in which there has been an orgy of
desktop speculation that has been at least one of the major factors in the derivative market growing out
of proportion to the real economy. It would also inhibit trading in contracts that amount to what one
might describe as "intra financial club externalization of the costs of prior unwisdom". Engendering
either workaholism or despair, and eventually cynicism and outrage, all of which attack social
coherence, speculation requires active and presently intelligent means of eliminating its destabilizing
effects on the economy as a whole in favour of directing the energies and spare capital of speculative
players toward investments more likely to be functional for the economy as a whole.
The key word in this concept of a smart financial transaction tax is, of course, 'deemed'. It raises the
practical questions of (1) who would do the deeming and, just as important, (2) how? To answer these
questions, let's consider a possible process in which three parameters that are common to all derivative
contracts are assessed automatically by computers. The assessment would, by reference to these
parameters, determine whether any particular derivative contract trade is aimed more at (a) meeting
the needs for short or long term project capital needs of real economy actors or (b) either externalizing
the risk of an already sunk capital investment or rent-seeking, both of which are, of course, corrupt
from the point of view of the economy as a whole. Such an assessment would, in effect, provide a
crude screen for identifying the more flagrantly predatory transactions, whether actively dishonest or
irresponsibly risky; and any attempt at their sale could then only rationally be considered
dysfunctional. Here’s how I (preliminarily) visualize such a process working:
1. A system is in place to register centrally and immediately the opening of derivative contracts (a contract
being an initiation or change of position with the market maker), including synthetic ones
2. A fee becomes applicable on the opening of a contract in those categories of derivative that trading
statistics show to be very large in gross amounts outstanding relative to recent figures for the sales rate of the
commodities or services to which the derivative contracts refer
3. The aim of this fee is to lessen the prospective profitability of those derivative transactions whose benefit
is predominantly the postponing -- until after the bonuses on "shorts", which bet on whether a large organization
will either survive or "go under", have been paid -- of the day of reckoning for financial institutions whose
shareholder's equity turns out later, in a "system-wide credit crisis" to have been squandered by such bets
4. Contracts longer than X number of days (parameter 1) or shorter than Y number of months (parameter 2)
would be exempted from this transaction fee on the ground that they would be unlikely to be dysfunctional to the
economy as a whole
5. The parameters X and Y would be figures established by a committee made up of both bonded derivative
traders and non-trading executives sworn not to participate in derivative markets of each of the
commodity/service categories involved, plus a government finance/treasury department (or central bank?)
6. Synthetic contracts composed of less than Z heterogeneous derivatives, where Z (parameter 3) would be a
figure established in a similar way to X and Y, would likewise be exempted from this transaction fee
7. The fee schedule, variable by category of derivative, would be set by each Category Committee and would
comprise (1) some function of the ratio of derivative traded volume to the volume of real goods traded, (2)
functions of whatever is agreed as either X days for short-term capital projects or Y months for long-term capital
projects, and (3) a further adjustment by some agreed function of Z
8. Targets for revenues from the contract initiation fees would be set by a committee made up of one
member from each industry committee plus representatives from the Central Bank and Government
Finance/Treasury officials whose concern will primarily be the stability of the financial system
9. The Category Committees would meet periodically at either their own behest or that of their nation's
Central Bank Governor or Finance Minister.
The fee contemplated in this scenario might be called a calibrateable "differentiated speculative
Financial Contracting Fee (dsFCF)". Well, it's a tax; but we can avoid the knee-jerk fear and animosity
toward any taxes by dyed-in-the-wool financial "conservatives" by calling it a fee until at least the time
when decisions on what to do with the revenue can properly be considered. G20 process leaders can
view the dsFCF as both a "rounding out" and a "better targeting" of the financial sector taxation
proposals already presented to them -- in a paper published by IMF staff in September, 2010. That IMF
paper is neither positive on the plain vanilla financial transaction tax (FTT) nor negative on one, and its
writers invite G20 leaders to make clearer the objectives they have, in the context of consideration of an
FTT. The IMF writers appear not yet to have examined the special merit of a "smart" FTT, such as the
dsFCF, in preventing what one might describe as "either manic or corrupt horses from breaking down
their stable door, holding their government and stable boys hostage, and wrecking the best-laid plans
of real-economy principals and tax-payers".
Lastly, on the technical practicability issue:
1. There are automatic text parsers that can pick out the "x", "y", and "z" parameters in FDC contracts
under the dsFCF calibration model so workability should not be a technical problem
2 The "z" parameter in the dsFCF calibration model will diminish the prospective profitability of
mixed derivatives such as those in securitized tranches of mortgages and hence divert energy away
from the most horrendous of the asset price bubbles that precipitated the Great Recession.
3. The moral hazard of irreconcilable ethics being unconscienably exploited by unscrupulous "players"
would, in the instance of the long lead up to the Great Recession, have become obvious to most honest
participants at least 12 months, if not more, before the Lehman failure. That means that intelligent and
responsibly sensitive settings by the category committees of all three of the "x", "y", and "z" parameters
would afford retail investors, real-economy actors, and taxpayers some protection against the size of a
bubble threatening financial instability -- so long, of course, as the selection process for the committees
visualized in the dsFCF model can be reasonably sure of excluding the conscienceless sharks that I
sense readers of this paper may be able to smell a mile off.
.................................................................................* * *
The question now is: Can political and financial majorities acknowledge that we have allowed the
financial sector to conflate speculation with investment and that this conflation of terms is a very
serious matter for both the real and the financial sectors? For an overview of major political
developments, beginning with the Toronto G20 Summit in June 2010, that seem to the author to bear on
the prospects for adoption of a dsFCF (or its predecessor idea the FTT, sometimes called the "Robin
Hood" tax), please feel free to review the following papers, each written shortly after the events they
After Seoul: a Plain Vanilla or a Smart FTT?
Derivative Market Oversight: How might a "smart" FTT work?
Regulating Derivative Markets To Meet Real Needs: Beyond Toronto to Seoul
(The author plans a follow-up to this concept paper -- on the subject of "The politics of successfully implementing an
increasingly cost-effective smart FTT". Since completion of this second paper will require inputs from many
quarters, the author invites comments, which he will treat with whatever degree of confidentiality is requested in
.................................................................................* * *
A profile of the author's career is available at this link. And a summary of the ethical principles by which his
coaching, consulting, and writing activities are conducted is available here.
|Although "the Street" adamantly claims otherwise, unconventional financial contracts can be classified,
prospectively, as either very likely to be dysfunctional from the perspective of the economy as a whole, or
otherwise. This paper, by a former coach to a manager of trading at a major international bank, explains how
such a classification can rationally be made. A new departure, it is nonetheless based on combining recent
empirical research by an IMF visiting professor with the growing recognition that not all types of such
contracts actually serve the economy of which they are a part, and it opens a practical door to the possibility
of a charge being levied at the writing or exchange of very-likely-to-be-dysfunctional derivative contracts in
order to inhibit the trading of more grossly destabilizing or strictly self-serving ones. Unlike the FTT widely
touted almost everywhere except among North American conservatives, such a charge would not "impede
the economy's functional financial babies to drain out the dirty bath water of dysfunctional ones".
Furthermore, a smart FTT, such as the dsFCF described here, would be more effective in lessening financial
instability, and it would also increase coherence between an economy's financial and real sectors. The
paper also sketches how such a charge might be calibrated to achieve these critical goals of financial reform.
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Clarifying Functionality in Derivative Financial Contracts:
The Case for a 'Smart FTT'
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Principal, Authentix Coaches