Return of the sledgehammer
By Daniel M. Ryan
web posted February 15, 2010
There are two kinds of libertarian in the world; the dividing line shows no more clearly than over the question of assault. The primal axiom of libertarianism is, "everyone should be free to do as (s)he pleases except for the initiation of force or fraud against another human being"; since assault is one of the clearest violations of that axiom, it reveals the divide most clearly.
One kind of libertarian says that there's no assault unless there's been an initiation of force that the victim complains about. This line is drawn because the term "assault" has a grey zone. If I accidentally jostle someone on the subway, then I've technically (although unintentionally) assaulted him. Playfighting without explicit beforehand consent has to involve at least one assault; so does roughhousing. There are some situations where the bully's favorite excuse – "I hit him back first" – has truth to it. Since a line is hard to draw in cases of what common sense would consider minor assault at most, the first kind of libertarian advocates a complaint-driven system. If the receiver says it's assault, and the initiation-force criterion has really been met, then assault it is. Provided that the allegation of assault can be proven, as people have been known to make false allegations. The current law, of course, distinguishes between criminal and civil assault.
This kind of libertarian has common sense on his or her side, as the formal-complaint bar allows for customs that many of us take for granted. However, another kind of libertarian marshals another kind of common sense. The trouble with the complaint-driven criterion is that it fails to stop a kind of victimization: assault combined with intimidation. Even if an assaultee is intimidated into not making a complaint, or is swayed by a counterproductive value system into not doing so, an assault has still occurred. The sanction of the victim means that the assaulter gets away with it. When the first kind of libertarian would say that nothing really happened, or that it was only technically assault, the second kind would say that assault did occur; it was just unpunished. Just as a murder being unsolved doesn't change the fact that someone was murdered, so it is that an unpunished assault doesn't change the fact that someone was assaulted. This kind of libertarian tends to be sympathetic to third-party intervention in cases of witnessed assaults. Both, typically, are mindful of the possibility of false accusations and thus see the need for procedural rights granted to a defendant.
I don't claim that every libertarian is completely one or the other, as those two categories are ideal types, but I do claim that there's an attitudinal difference that does show up in intra-libertarian debates. The first kind tends to be emotionally sympathetic to free banking, while the second kind is inclined towards what I've called "The Sledgehammer": 100% reserves on demand deposits. The first theory says that banks should be only be held to market forces when it comes to reserve policies, as customers' oversight and bankers' fear of losses is oversight enough. The second, in its pure form, says that anything less than 100% reserves on demand deposits means using the same dollar twice; customer complaisance doesn't change the fact that some dollars have been created out of thin air. The parallel with the different attitudes towards assault should be evident.
100% Reserves Applied To Derivatives
No matter how complex, a derivative is a security that derives its value from one or more other securities. Tracing a derivative to its underlying security or securities may be complex in some cases, but the relationship is still there.
A regular security is only backed by a contractual relationship governing "real" (non-securitized) assets, including cash. A share of stock is the right to a certain percentage of a company's assets. A bond is the right to a certain part of a specified term loan. Some securities have features that make them apparent hybrids, like income bonds or preferred stock. The former pays interest only if the company has earnings to make the payment; the latter limits the dividend payout while giving the owner a higher-priority claim than a common stock holder gets. Despite such blending, a security is either equity or debt; it's either backed by either a claim of ownership or a loan indenture.
The simplest kind of derivative is like a transferable rain check: the right to receive a specified quantity of security at a fixed price for a certain time period. If I have a certificate that entitles me to acquire 50,000 shares of a penny stock at fifteen cents each, and it expires in early 2011, then I have the right to send the issuing company a check for $7,500 by the expiry date and receive a 50,000-share certificate in exchange. This kind of certificate, called a "warrant," has a value all its own as long as the stock in question trades for more than 15 cents, or there's a reasonable chance of it doing so sometime during the life of the warrant. If it's unexercised by the time it expires, it becomes worthless. If the stock price is at or below fifteen cents at that time, and the warrants have been unexercised, then they have no intrinsic value. It's not worthwhile to exercise them.
(I'm leaving aside complications due to illiquidity. Large blocks of warrants at fifteen cents per for a stock selling at 14.5 cents, can have convenience value if the warrant block is large and the stock is thinly-traded. 1 million warrants at 15 cents for a stock trading only 50,000 shares at 14 or 14.5 allow the holder to buy a large chunk of shares at 15 cents. Buying 1 million cheaper at market may be impossible because there aren't enough offers to make for an average price of 15 cents, even though the lowest offer is slightly below that number. In this case, the warrants have convenience value even though they're intrinsically worthless.)
The next simplest kind of derivative is a security that represents an ownership claim to one or more different securities: typically, a "basket" of them. The simplest example of such a derivative is a fully-invested mutual fund, like an index fund. Or a T-bill money-market fund. Yes, a mutual fund is a kind of derivative.
A third basic kind is a reverse warrant, which grants the owner the right to sell a certain quantity of a security at a guaranteed price. It's like a rain check issued by a buyer to a seller, and works in reverse fashion to the warrant example above. Its closest real-world equivalent is the put option.
A fourth kind is a splitting of a regular security's obligations and assigning each to different parties. A mutual fund that entitles the owners to only the dividend payments from a stock, or basket of stocks, and a companion fund that entitles the owners to benefit from the appreciation of the same stocks or basket, are splitting derivatives of this sort. They're more common in the fixed income department. A simple example of a split derivative is a synthetic zero-coupon bond whose value is derived from a regular bond; the rights to the bond's interest payment are owned by someone else. The holder of the synthetic zero is only entitled to return of principal once the bond matures; nothing else.
A fifth kind is like an insurance policy, which makes certain losses whole. Ironically, the most complex derivative bandies about – credit-default swaps – are anchored in this simple conceptual framework.
All derivatives, no matter how complex, have a family resemblance to at least one of the above five kinds. (Some are compound derivatives.) Given that relationship, it's easy to see how a 100%-reserves policy fits in. In the case of the warrant, the company must have the shares issue and in the company treasury. If issued by a third party, said issuer has to have the underlying shares. In the case of a mutual-fund type of derivative, the issuer must own the underlying securities. In the reverse-warrant case, the issuer must have enough cash to meet the contractual obligation to buy. In the insurance case, the issuer needs enough reserves to meet the obligation like a regular insurance company has to. Regarding these kinds of derivatives, the connection to a 100% reserve banking policy is fairly obvious.
Objections
Common-sensical as it may be, advocating a 100%-reserves policy to people in the derivatives field is less likely to be met with an objection than a snicker. That's for two reasons: borrowing facilities and offsetting derivatives. In the case of a straight warrant, it seems superfluous to the issuing company to pre-issue the shares and keep them in treasury, as the warrant may not be exercised. Granted that the case of a mutual fund is more dubious, as it is for its more complex variants, but it could be argued by someone with a little brass that the company need only keep enough cash – and/or enough of a line of credit - to purchase the underlying securities. What makes that argument unconvincing is the fact that the prices of the underlying securities change, incurring the risk that the issuing company won't be able to buy what it claims to hold. In the case of a reverse warrant, all that's needed is access to cash; a borrowing facility might suffice.
The second reason pops up in the case of offsetting derivatives, ones that confer opposite rights to the other. To take the warrant example: if I've sold an obligation to buy 1,000 shares of ABC at $50 per, which gives the buyer the right to sell them to me at that price, I'm going to need $50,000 to meet that obligation if the owner of it exercises his or her right. However, if I myself buy the exact same kind of right, then I've canceled the original obligation out. There are two warrant-like contracts giving the right to sell 1,000 shares of ABC to the issuer at $50 per share, but I'm on both ends of each of them. At this point, the cash commitments of the contracts are merely notional. I don't have to put up a dime; all I have to do is exercise my own right to sell to someone else. The shares and cash merely pass through my hands in opposite directions.
The same offsetting applies to all the other kinds too. What makes the fifth variety complicated in the offset department is the statistical nature of insurance. Offsetting that kind of derivative is like buying reinsurance, which serves as a just-as-good ersatz offset.
To be more specific, the above is the way it works in normal circumstances. In order for the two offsetters to truly offset, unless I buy the specific obligation I incurred from its original buyer, I have to depend upon another party to pony up the cash I need to fulfill my own obligation. The chance that someone's left hanging is called "counterparty risk." If I'm hung, then I suffer from my counterparty's failure to meet his or her obligation. If I'm irresponsible on my end, the buyer of the right I sold suffers from the counterparty risk I've incurred. In each case, I would be at the opposite end of what could be called a "counterparty event." Note that if I'm left hanging, and I have no backstop that suffices, I'll leave the buyer of my own obligation hanging too.
Writ large, such "counterparty events" imploded the derivative markets in the crisis of '08 because the backstops proved to be insufficient in the crunch. When counterparty risk enters the picture, there's a little more than nitpicking behind the point that "fungible" is not the same as "identical." In the banking world, fractional-reserve banking is subject to counterparty risk too. That why bank runs ruin banks, and why even a bank with 100% reserves on demand deposits and perfectly matched maturities between loans and deposits still needs a capital cushion. The chief difference between a fractional-reserve bank and a 100%-reserve bank is the former has an imbalance in term of legal obligations. To use the ABC example just above, "fractional-reserve issuance" would be me issuing an obligation to buy the 1,000 shares while only having only $25,000 in my own account, with a margin-loan facility and/or other securities to make up the deficit if I need to.
To come back to the libertarian divide, the person partial to free banking would advocate no restrictions on the issuance of any derivative, saying that customer scrutiny and issuer loss/bankruptcy risk is enough to assure that derivative issuance doesn't get out of hand. Since each party is on the spot and has money at stake, buyer scrutiny and seller-self-restraint should be enough.
The person who's a natural 100%-reserves advocate would take a completely different tack. The fractional-reserve derivatives issuance model all-but assures counterparty risk and contagion, just as it has in the banking sector. Whether or not there's misrepresentation regarding the true number of underlying securities, there's still the fungibility vulnerability. Fungible is not equivalent to identical.
As should be apparent, what's called "laissez-faire" is only one of two variants of the breed. The second is so far from real-world practice, it's confined only to academic organizations like this one. Ironically, two different kinds of libertarian have two different positions that seem to be opposite extremes.
Of course, they're far closer than they appear. That's because both varieties oppose government bailouts in principle. However, in the real world of compromises, each strain does show its true colors. 
Daniel M. Ryan is currently watching The Gold Bubble.