Employment derivatives
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.
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Genesis
When midway through his annual rant about the meaningless of life as viewed through the lens of his income, Hunter Barkley had an epiphany. For sure, his own pay packet was a material, unhedged contingency in his life. The perpetual disappointment that it rained upon his sorry existence had, he knew, little to do with how good he was at it (work, or existence for that matter). He knew, too, that his experience was common to the great dreary sweep of humankind that crawled blearily across the clanking gears of global industry.
That was not his revelation, but this: just as that great collected horde of mortgaged servants were severally at the whim of wanton Gods, so too, necessarily, were the employers who stood the other side of the trade. Firms were long what their servants were short. Only at a far greater scale. Businesses — particularly boring businesses — bobbed ineptly at the mercy of hysteria’s fickle tides when they flood the market.
An employer of turgid multitudes — a good-sized bank, for example — was in a constant war to prevent its pedestrian operations personnel from being lured away by exciting but stupid enterprises enraptured by the latest techno-craze. Just the effort to stem the outflow might cost a bank billions of dollars.[1] As the inflated expectations in the new sector foundered, the bank would find itself spoilt for choice and its wage bill would collapse.
In any case, this employment cost volatility bore little relation to the bank’s own performance, none at all to its employees’. It was a simple measure of that background market euphoria. Different types of firm were “long” or “short” this babbling hysteria, which he labelled π,[2] at different points in the hype cycle.
At its onset, “trad-fi”, “bricks-and-mortar” firms are short, and delusional start-ups, long π. Eventually, the lunacy levels off. As reality sets in and employment relations revert to mean, the π curve flattens and then eventually inverts. If one could only match off long and short exposures, Barkley realised, firms on either side of the bid could hedge their exposure to π.
In one of those cruel ironies to whose martial cadence our lives keep time, Barkley was laid off and, shortly afterwards, imprisoned for manipulating LIBOR, before he could figure out a way of monetising his idea.
A chance encounter
Barkley’s fortunes would change following a chance encounter in an upscale cocktail bar in West London. As she neared her gin horizon, HR manager Anita Dochter, was bellyaching to her old pal and erstwhile colleague Cass Mälstrom, about the unstaunchable stream of defections from her firm, a sleepy mid-market broker headquartered in Peterborough.
At the time the firm was haemorrhaging hundreds of compliance and onboarding staff each month to venture capital-funded dot-com start-ups. Mälstrom herself had been plucked from the firm’s client money compliance programme to be Co-deputy CIO of legaltech darling lexrifyly not three months earlier. lexrifyly 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 goosing its burn rate by overpaying for bums it didn’t need on seats it didn’t yet have.
“But,” complained Dochter, “we actually need our people. They actually do productive things for us. You know: MIS reports. Operational deep dives. Netting audits. But unless we pay your stupid rates for them, 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 hissed, clambering back up and jabbing Mälstrom on the lapel, “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. That does not take actual staff. So stop taking ours.”
As luck would have it Barkley, fresh out of gaol and making ends meet waiting tables, was their host for the evening. Presenting them with the check and some after-dinner mints, he cleared his throat.
“Forgive me for imposing, but I could not help overhearing. If you are not actually hiring anyone, why not hedge your employment rate risk to someone who is?”
Dochter fell off her stool again.
Barkley dropped a slim document on the table.
Mälstrom indicated the booklet. “What’s this?”
“NDA. Call me.”
The first employment rate swap
So was the very first “employment rate swap” conceived. For an initial period of three years, Wickliffe Hampton would pay its entire operations wage bill, controlled for performance, to lexrifyly. In return, lexrifyly would pay its absurd, grossly inflated but as yet unallocated wage budget for an equivalent team — there was no such team, of course: this was exactly the point — to Wickliffe Hampton.[3]
This way, Wickliffe Hampton had the cash required to preemptively bid back restless staff, and lexrifyly could, in time-honoured fashion, guilelessly piddle its investors’ cash up a wall without troubling the operating resiliency of the banking sector, or for that matter, the HR department.
If this seemed like a bad trade for lexrifyly, in actuality it was not.
Firstly, it didn’t care: what was money, when it came to it? Secondly, Barkley’s models demonstrated that the economics could change in any number of circumstances: for example, a market crash, hawkish monetary policy, the dissipation of mass hysteria or incipient tech winter. At that point, widescale redundancies and hiring freezes were sure to follow across the sector, while the boring old banking industry would box on as it always had done.
Ironically, at that point, a startup short π under an ERS would have a sensible amount of cash coming in from its bank counterparty to keep the lights on.
The “PIEBOR” submission process
It was easy enough to quantify a bank’s presumptive wage bill since, once it was controlled for hysteria, it was more or less a fixed rate. But what about the ever-changing hypothetical wage bill of a startup? How to gauge that in real-time? And could not a startup not game this very easily, by just pretending its actual preparedness to pay stupid money was lower than it really was?
The market needed an observable, objective measure of “prevailing startup insanity”, which Barkley denoted “π”. He had just the means to achieve it. Under the auspices of the British Human Capital Managers’ Association (BHCMA), he arranged for a committee of fashionable startups to meet each afternoon in a WeWork in Shoreditch and over kombucha martinis 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 clerk to join them and drive customer engagement. They expressed this as a premium of discount to π', being the equivalent value for the preceding day.
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 (PIEBOR). PIEBOR quickly became the de facto measure of π and was soon factored into the “floating” leg of employment rate swaps as standard.
Credibility spread
LIEBOR was not the only component of an individual swap: short counterparties would also be assigned a weighted average “credibility spread” over (or under) the prevailing LIEBOR rate. This was a competence assessment made by independent human capital rating agencies of the median quality of a given counterparty’s staff, routinely marked to market and adjusted by way of a 360° credibility appraisal process.
The credibility rating could yield anomalies. Though HR departments assiduously graded staff against an internal 5-point scoring metric and would force-rank staff to a curve, there remained risks that employee “alpha” could be mispriced or too overly concentrated. Furthermore, interdepartmental secondments were beset by credibility rating, diversity arbitrage and cheapest-to-deliver scandals, especially over quarter end.
Meantime, the need for periodic reductions in force was greatly reduced and could be handled quantitatively without reference to individual performance or value — as that was baked into the portfolio 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.
Expansion
By this financial engineering Barkley had unwittingly created a tradable instrument out of an abstract benchmark. Due to the offsetting nature of ERS transactions one needed to be neither long nor short actual staff but could trade directionally on abstract π without having a job, or any workers, at all. These “synthetic” instruments were valuable for sectors affected by the vagaries of the labour market even where not themselves directly exposed to it. Recruitment consultants, employment lawyers, HR Consultants — that kind of thing.
Individual workers began to buy π-linked contracts for difference as a way of laying off their own intrinsic loyalty discount, a sort of negative carry that comes from unreflective devotion to a single monolithic corporation. This restricted the need to quit to a narrow run of unmanageable idiosyncrasies such as cultural fit, business relocation and visceral hatred of the boss.
Before long more exotic ERS payoffs emerged. Capital protected RIF puts, employment collars, diversity forwards and synthetic collateralised gender pay gap swaps. All these risks, and more, could be managed in the hypothetical with out adjusting the physical staff roster at all.
Banks even began selling employment derivatives directly to their employees, saving the bother of having to hedge themselves.
So began the sad chronicle of employment rate swap mis-selling. In this dark episode, banks would separate the employee’s fixed rate, and pay that under a physical employment contract, then separately hedge out their π risk with a linked derivative. Before the emergence of ERS, the π risk was intrinsic to the employment contract and could not be abstracted and traded separately.
The scandal blew up when it emerged HR departments were being offered incentives to place employee counterparties on performance management, arranging with other firms to bid them away or just peremptorily layingthe employee off, leaving her holding a twenty-five year out of the money employment rate swap and badly exposed should crypto go tits up.
Such “self-referencing employment derivatives” are now not permitted in many jurisdictions, and attract penalty risk weighing in the UK.
See also
References
- ↑ The maths was like so: assume 40,000 people at an average total compensation of about $300,000, with a ratio of discretionary to fixed of between 20% and 50%
- ↑ From the Greek παράνοια, (paranoia). It was also pleasing that π conveys circularity, running on a hamster wheel and so on, all of which Barkley recognised to be fundamental properties of the employment relationship.
- ↑ This was slightly complicated as it was denominated in crypto and needed to be converted back to Sterling.