Employment derivatives

Myths and legends of the market The JC’s guide to the foundational mythology of the markets.™ →Go uptown Index: Click ᐅ to expand: Mythology Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

Employment derivatives
/ɪmˈplɔɪmənt dɪˈrɪvətɪvz/ (n.)
Financial instruments designed to manage the risk of employment variability. First developed in the early part of this millennium by derivatives pioneer and perennial boiler of pots, Hunter Barkley.

Genesis

When midway through midway through his customary annual rant about the meaningless of his life as viewed through the lens of his pay packet, it struck Barkley — an amateur fi-fi novelist, financial services naturalist and tiresome windbag, not in that order — that just as his own fortunes at work were a material, unhedged contingency in his life having little to do with how good he was at it (his work, or life for that matter), so too waa everyone else’s.

This included, at far greater scale, his employer. Barkley believed himself, rightly, to be short an ugly option to the Man. But by the same, token so too was the Man short an option to crowd hysteria.

A good-sized bank would have an annual variance in its total wage bill, even before accounting for changes in in its staff, in the billions of dollars.

This bore little relation to the bank’s own performance, none to its employees’, and a lot with how other employers were doing in adjacent sectors.

Barkley reasoned that different types of firm were “long” or “short” the babbling hysteria that drove the employment market. Barkley called the measure of this “madness” characteristic π. At its onset, “legacy”, “bricks-and-mortar”, “trad-fi” firms were typically short π and start-ups long. As the lunacy tailed off and employment relations reverted to mean, the π curve would invert. If one could only match off a long and a short firm, they each could hedge changes in π.

Human capital management trading staff were apt to talk about “benchmarking”, as if there were some indexed rate.

Perhaps there should be, reasoned Barkley. It was easy enough to calculate this variance, but knowing about it was a different thing to managing it. Instinctively, he knew there was something in this idea but could not figure out a way of monetising it.

In one of the cruel ironies to whose cadence his unremarkable life kept time, Barkley was laid off shortly afterwards and obliged to find work wiping tables by night as he worked on his novels and developed his derivative ideas

The first employment rate swap

Barkley’s fortunes would change following a chance encounter in an upscale cocktail bar in West London. As she neared her gin horizon, Wickliffe Hampton’s Chief Operating Officer Anita Dochter bellyached to her former trainee, now lexrifyly’s CEO, Cass Mälstrom.

At the time, Wickliffe Hampton — a sleepy mid-market broker — was losing hundreds of compliance and onboarding staff each month to venture capital funded tech firms, while lexrifyly, was just the sort of legaltech startup darling that was poaching them: it had no product to speak of, no business model, customers or plan but was flush with stupid amounts of cash, a great deck and an unshakable conviction in the wisdom of goosing its burn-rate by hiring lots of staff.

“But,” complained Dochter, “we actually need our staff. They actually do productive things for us. But unless we pay your stupid rates, which we cannot afford to do —” at this point she fell off her stool briefly — “and give them free fruit, unlimited working from home and a soft play area — they won’t stay with us. But, you,” she continued, clambering back on and jabbing Mälstrom in the chest, “right now, you don’t need any goddamn staff: you just need to show your investors you are clever, imaginative and on point doing fashionably insane things. This does not require actual staff. So stop taking mine.”

As luck would have it, Hunter Barkley was waiting tables that evening and overhead the conversation. He presented them with a pitch book with the check: If you are not actually hiring anyone, why not hedge your employment rate risk of not doing so?

So was the first “employment rate swap” conceived.

For an initial period of three years, Wickliffe would pay its entire operations wage bill, controlled for performance, to lexrifyly. In return, lexrifyly would pay its absurd, grossly inflated but actually unallocated wage budget for an equivalent sized-team — there was no such team; this was exactly the point — to Wickliffe Hampton.

This way, Wickliffe Hampton had the cash required to preemptively bid back restless staff, and lexrifyly could guilelessly piss its investors cash up a wall without troubling the operating resiliency of the banking sector, or needing an HR department.

If this seemed like a bad trade for lexrifyly, (a) it didn’t care: what was money? and (b) ther economics would change markedly should there be a tech winter with widescale redundancies and hiring freezes. And ironically, at that point, it wold have sensible amount of cash coming in from Wickliffe Hampton that it could use to hire some people.

It was easy enough to quantify Wickliffe Hampton’s presumptive wage bill: it was more or less static. But what about lexrifyly’s fantastical aspirations? How to gauge those in real time? And could not lexrifyly game this very easily, by just pretending its wage bill was lower?

The “LIEBOR” submission process

What was needed, Barkley reasoned, was an observable, objective measure of startup insanity, π. He had just the means for achieving it. Under the auspices of the British Human Capital Managers’ Association (BHCMA) a committee of fashionable startups would meet each afternoon in a WeWork in Shoreditch for an kombucha martini and to state publicly, in front of a live panel of venture capitalists, how much they would be prepared to pay an underperforming settlements and reconciliations specialist to join them and drive customer engagement.

The BHCMA would trim the top and bottom estimates, average the remainder and compile and publish the trimmed arithmetic mean rate as the London Inter-Employer Basic Offered Rate (LIEBOR). LIEBOR quickly become the de facto measure of π and was soon factored into the “floating” leg of employment rate swaps as standard.

The banks could even sell these derivatives directly to employees, saving the banks the bother of having to hedge themselves. By the same token employees could hedge away their intrinsic loyalty discount, and restricting their need to find new jobs to genuine changes in role or idiosyncratic hatred of their bosses. But there was no need to simply “benchmark” themselves periodically any more.

Credibility spread

LIEBOR was not the only component of an individual swap: each employee would also have a performance-related “credibility spread” over (or under) the prevailing LIEBOR rate. This was a competence assessment made by human capital analysts. Mispricing this could lead to staff defections, to it was routinely marked to market and adjusted by way of a 360° credibility appraisal process.

For portfolio transactions (like the first ERS, which was departmental-wide) analysts would assign a weighted average credibility spread. This could yield occasional anomalies. Though HR departments assiduously segmented staff according to an internal 5 point scoring metric (a “credibility rating”), and would force rank staff to a given curve there remained risks that exposure to employee “alpha” could be mispriced or too overly concentrated.

Interdepartmental secondments were beset by credibility rating and diversity arbitrage and cheapest to deliver scandals especially over quarter end.

Meantime, while periodic RIFs were greatly reduced they were not eradicated entirely, but now could be handled quantitatively without reference to individual performance or value — as that was baked into one’s credibility rating.

This led to the curious phenomenon of staff with the highest credibility ratings — ergo those who were, “pound for pound”, most expensive — being the first to go. This was of a piece with the theory that firms actively discouraged excellent employees, preferring those to meatheaded to do anything rash like using initiative.

Expansion

Barkley also saw the opportunity to trade the instrument as an abstract benchmark, for which one did not need exposure to the employment market at all. Thus was made possible by offsetting nature of ERS transactions. You needed to be neither long or short actual staff but could trade directionally on abstract π.

This led to a proliferation of exotic ERS products, many with me practical utility and unintuitive consequences. So began the sad chronicle of employment rate swap mis-selling. In this dark episode banks would separately hedge out their employee’s π risk, to the employee herselfand then peremptorily lay the employee off, leaving her holding a twenty five year out of the money employment rate swap. And badly exposed should crypto go tits up.

See also

• Interest rate swap mis-selling scandal
• Credibility derivatives