Codes of Finance Engineering Derivatives in a Global Bank

Codes of Finance Engineering Derivatives in a Global Bank Vincent Antonin Lepinay Submitted in partial fulfillment of the requirements for the degree of Doctor of Sociology in the Graduate School of Arts and Sciences COLUMBIA UNIVERSITY 2011 © 2011 Vincent Antonin Lepinay All rights reserved Abstract Codes of Finance Engineering Derivatives in a Global Bank Vincent Antonin Lepinay Codes of Finance is an ethnography of a global bank inventing new derivative products. It describes the multiple languages invented to describe and control these new products. It analyzes the recent discussions about financial derivatives and offers a new framework to understand financial innovation. Contents Acknowledgments Preface: Financial Innovation from within the Bank Prologue: A Day in a Trader’s Life Introduction: Accessing the Organization of the Bank and Asking Questions about It Part I. From Models to Books Chapter 1. Thinking Financially and Exploring the Code Chapter 2. Hedging and Speculating with Portfolios Part II. Topography of a Secret Experiment Chapter 3. The Room as a Market Chapter 4. The Memory of Banking Part III. Porous Banking: Clients and Investors in Search of Accounts Chapter 5. Selling Finance and the Promise of Contingency Chapter 6. The Costs of Price Chapter 7. Reverse Finance Conclusion: What Good Are Derivatives? Notes Bibliography i Acknowledgments Michel Callon and Bruno Latour generously read versions of this book. Its felicitous moments owe them much: in different styles, they have always been present, extending their supervision to a protective attention that nurtured a unique environment and great relationships. At the Centre de Sociologie de l’Innovation, other scholars also were helpful readers; Fabian Muniesa stands out as a great intellectual companion. A group of us initiated the Associations d’Etudes Sociales de la Finance (“Social Studies of Finance Association”) in Paris in 2000. Made up of young social scientists, we have met consistently since then, creating an environment that fosters lively conversations informed by a common interest in financial, monetary, and banking issues. With its members coming from different intellectual schools and endowed with very limited financial means --not to say surviving on a shoestring --the association has forced participants to engage the technicality of finance and take the risk of theorizing from the technique itself. Soon after, other clusters of scholars from the social sciences working on finance --sociologists in Germany around Karin Knorr Cetina and Alex Preda, in Scotland around Donald MacKenzie and Yuval Millo, and in the United States around David Stark and Daniel Beunza, geographers in England around Nigel Thrift, and anthropologists in the United States around Bill Maurer and AnneLise Riles --came together in an informal social studies of finance community. The community took shape through a series of conferences in New York, Konstanz, London, and Paris. Codes of Finance was born from this protracted discussion. Its many contributors --too many to name each --are here ii warmly thanked for fueling a growing interest for financial matters. Ellen Hertz occupies a special role as she became a co-writer as I was finishing my dissertation and opened me to what has become my next project, the complex relation between finance and law. A few individuals have helped shape the book and deserve special mention. In New York City, Peter Bearman, David Stark, and Harrison White helped me open up to American sociology after a solid indoctrination in continental sociology. I owe special thanks to David Stark, who saved me from the prospect of a slow death in French academia when he invited me to Columbia University. This book has been long in the making. The fieldwork and the interviews themselves spanned only two years, but once the academic exercise of the dissertation was over in 2004, life resumed, and its grip has been felt in many ways and has slowed the transformation of the dissertation into a book that is enjoyable to readers outside its circle of committee members. As the book waited patiently in the Drawer of Dissertations, my wife Verena gave gave birth to our daughter and son, happily slowing down the process of rewriting. More than anybody else, they made the experience more enjoyable. iii Preface: Financial Innovation from within the Bank This book sets out to make sense of financial innovation by documenting how a new product --the capital guarantee product (CGP) --that was used by a bank, General Banki, caused the disruption to the bank’s orderly organization. It is an attempt to understand what happened to financial actors (engineers, traders, salespeople, regulators) after they began to invent services that changed their way of making deals, eventually unsettling their businesses.ii Disruptive financial engineering left not only regulators puzzled and often unable to make sense of the risks generated by the innovative financial products, but also unsettled the bank that was expecting to adopt and exploit the innovations.iii What happens to an institution that sells products that undermine its organizational structure? Peeking into General Bank’s radical financial engineering offers us a rare glimpse of the relations among otherwise distinguished modalities of innovations. In this text, products, processes, and organizations are studied together. The finding of the book is that of a self-defeating form whereby a bank’s organization undermines its financial practices, and unstable securities designed by the bank destroy its infrastructure. Over the past thirty years, financial innovations have dramatically changed the way in which companies and individuals can manage their assets. Now, as many companies and even more households observe the dire consequences of innovative financial products, it is fair to wonder whether any of these products are well understood by the financial actors themselves?iv Once set loose in General Bank, these innovative products produce a number of unexpected consequences, straining the ability of dozens iv of operators who are baffled by these tortured formulas --physicists, mathematicians, legal scholars, and, last but not least, folk psychologists in search of the ultimate law of market. But who really understands the language of this new breed of finance? Codes of Finance is not a narrow book about the financial crisis that has struck the world economy since 2007. Many studies (MacKenzie 2010, Tett 2009) provide interested readers with illuminating accounts of the factors that led to that crisis, but they adopt a focus that both takes them close to the unfolding of events and can make them lose sight of the bigger picture. They characterize the crisis on the backdrop of a nonfailing financial system, but that leaves them to not question the proper objective of finance. Critical accounts of finance, predating the current situation, have long pictured finance as a genetic expression of the capitalist economy’s crisis-in-the-making (Minsky 1982, 1986). Codes of Finance scrutinizes the consequences of financial engineering on a specific bank by looking at the disruption triggered by products that pushed finance --in the form of derivations --to its ultimate consequence. As such, the book documents closely and engages the ever sophisticated financial innovations upon which finance critics have long glossed, yet without grounding them in the manufactures of finance themselves. CGPs are instances of derivative finance. Despite being designed and traded in the civilized business district of La Defense in the wealthy and orderly western suburbs of Paris, they are part of a world of finance that plays cat and mouse with regulation. Financial economists, chief among them Nobel Prize laureate Merton Miller (1986), have famously characterized financial engineering innovation as a market reaction to regulations.v This binary opposition --regulation versus innovation --has the drawback of caricaturing the process of engineering. It portrays innovation as a one-sided escape, whereas in actuality v it is a complex dance where innovators simultaneously dodge and exploit existing rules and infrastructures. If innovations operate in a preexisting ecology of financial rules and products, then the key question becomes that of their insertion therein; and if the task of social scientists should be more than the production of propaganda for financial engineering, then it could very well be to document the consequences of such innovations. Over the past decades, some sectors of the financial industry have pushed these operations to their limits and have shown that innovation can have disastrous effects on the economy. This destruction was no real surprise. Economist Joseph Schumpeter (1942) had long pointed to the inner paradox of capitalist economies that thrive through destructive creations. With his sober assessment of these economies, Schumpeter could anticipate that they would run out of steam should innovators be stifled. But what if the unleashing of financial innovation were to destroy capitalist economies? What if creative destruction were to lack any creation? Codes of Finance sides with neither Schumpeter nor Miller’s account of innovation in relation to regulation. Rather, it dissects a highly innovative financial engineering episode and lays bare the specificity of derivative finance. If derivation denotes a mode of operation that survives by a high level of innovation and by a lack of accountability, then it entertains more

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