Employment derivatives

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Employment derivatives
/ɪmˈplɔɪmənt dɪˈrɪvətɪvz/ (n.)
A financial instrument 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 were 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 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 variance bore little relation to the bank’s own performance, none to its employees, and a lot with everyone else’s performance. The market. 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.

Barkley reasoned that different types of firm were “long” or “short” the babbling hysteria drove the employment market. Barkley called the measure of this “madness” characteristic π. Upon 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.

The first ERS

The first so-called “employment rate swap” was thereby conceived between sleepy, ops-heavy mid-market broker Wickliffe Hampton, at the time losing hundreds of compliance and onboarding staff each month, and lexrifyly, a legaltech startup darling with no product, business model, customers or plan but flush with stupid amounts of VC cash, a great deck and an unshakable conviction in the wisdom of goosing its burn-rate by hiring lots of staff.

It started with a chance encounter at a swanky soiree 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.

“But we actually need the staff,” she complained. “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 from her stool briefly — “and give them free fruit, working from home and a soft play area — they won’t stay with us. But, you,” she continued, 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, you could be hedging your employment rate risk of not doing so.

For an initial period of three years, Wickliffe would pay its wage bill for its entire operations team in London, controlled for performance, to lexrifyly. In return, lexrifyly would pay its absurd, grossly inflated wage budget for an equivalent sized-team 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.

It was easy enough to quantify Wickliffe Hampton’s wage bill: it was more or less static. But what about lexrifyly’s fantastical aspirations? 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. Barkley 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.

Then 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 defactor rate to be factored into the “floating” leg of employment rate swaps.

In this way could trad-fi bankers hedge their π exposure.

Retail employment rate swaps

Employees could do the same, hedging against their intrinsic loyalty discount, and restricting employee moves to genuine changes in role, or idiosyncratic hatred of boss, rather than just the need to rebenchmark periodically.

A firm having a bad year while its competitors feasted had no option but to hike pay to stop flush rivals piratically raiding its meagre stocks of human capital. By the same token, a firm that was knocking the ball out of the park while its competitors floundered, did not need to pay its own staff outsized bonuses. Where were they going to go?

Legend has it, should she ever be asked for a raise, the Vampire Squid’s fearsome GC would theatrically throw open a draw stuffed with unsolicited resumes. “I am sure we’ll find someone to do your job if you’re too good for it.”

Now this only works when the industry is not in the grip of some mania or other. History tells us usually it is: dot-com startups, hedge funds, crypto and private equity have all skewed the market for unremarkable drones in recent times. This is why magic circle firms pay guileless trainees two hundred grand and then have to charge them out at £600 an hour. But I digress.

Expansion

In any case, the option is ugly, whether you are long or short, on either side. Even for a Vampire Squid. Usually, banks were structurally short a rising bid. If rapacious private equity firms or gormless crypto startups were swiping mid-ranking harness bulls from their operations department, banks had little choice but to follow the bid — for replacement hires. They thereby had “duration risk”: current staff would put up with a certain amount of stiff-arming, but there were limits: human capital management desk traders priced staff like fixed rate term debt with a three-month call. New staff would come in at the prevailing astral rates, so HCM hedging strategies were vital.

Enter Barkley’s invention: employment rate swaps promised to change that by tanking lateral movements — which were necessarily highly entropic in that they cost a lot in transaction friction, institutional leakage and so on and which could be avoided by just paying the employees more.

The banks could sell these derivatives directly to employees, saving the bother of having to hedge themselves.

Barkley also saw the opportunity to trade the instrument as an abstract benchmark, for which you need not be employed at all. So did banks, unfortunately, and so began the employment rate swap misselling scandal during which banks would separately hedge out their employee risk and then peremptorily terminate the staff member’s employment, leaving her holding a twenty five year out of the money employment rate swap.

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

It led to anomalies. HR departments would segment staff according to an internal 5 point scoring metric (a “credibility rating”), and would force rank staff to a curve, lest the banks exposure to employee “alpha” became too concentrated.

Interdepartmental secondments were beset by cheapest to deliver strategies and diversity arbitrage, particularly over quarter end.

Meantime while periodic RIFs were greatly reduced they were not avoided entirely, and now could be handled quantitatively without reference to performance or value as it was baked into the credibility rating. This led to the curious counterintuitive phenomenon that the staff with the highest credibility ratings — ergo the most, well, “pound for pound” expensive — were the first to go. This assisted also in the force ranking process.

See also

• Interest rate swap mis-selling scandal
• Credibility derivatives