Employment derivatives
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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 yet another junior customer services manager quit for a crypto startup, Hunter Barkley had an epiphany. His own salary, he knew, was an unhedged contingency apt to rain disappointment across his meagre aspirations. However much he liked his job — it had moments of passable distraction — and however good he was at it, he had little practical control over how much he was paid to do it. He was, in the argot, structurally long an option to the market, though one that was stubbornly, deeply, out of the money. In a time of expansion or innovation, when demand was high, his salary should ratchet up in pleasing annual notches. In times of recession it would not. The record of his own payslips reflected a greater preponderance of “not” than was optimal.
This dispiriting experience, he supposed, was common to the great, dreary sweep of humankind as it clambered blearily across the clanking gears of industry.
Received wisdom had it that there was only one way to medicate, and that was to catch one of the waves of hysteria that periodically swept the market, and ride it to a better-paying job. This was cold comfort for Barkley. He was no surfer.
In any case, that was not the revelation, but this: just as the horde of wage slaves were, severally, at the whim of wanton Gods, so too were their employers. Logically, they must be: the firms were on the other side of the same option after all.
Firms — particularly boring ones — were short what their servants were long, only at a far greater scale. As the hype cycle crested and troughed, unglamorous firms bobbed ineptly upon Hysterion’s fickle ebb and flow.
Now, thought Barkley: if a single worker has but one unit measure of this risk, the firm she works for her has thousands.
A corporation employing tired multitudes to turn its turgid wheels — a good-sized bank, say — is locked in a constant struggle with this tide of batty expectation just to stop its human capital from washing away.
At fault were the exciting but stupid technology enterprises whose sails the voguish delusion filled.
In times of giddy optimism, stemming this outward tide could cost a bank billions of dollars. Then, as inflated expectations foundered, the tide would turn. Throngs of good workers would be suddenly available, on the cheap. Firms could rebalance by tactical redundancy, but it was expensive and tended to dent morale somewhat.
In any case, this “employment cost volatility” bore little relation to the bank’s own performance and none at all to its employees’. The bank’s personnel needs had not changed across the cycle. Surely it would be better just to keep the same staff throughout?
An idea
Hunter Barkley’s experience as an interest rate swaps trader gave him an idea. Why not hedge this volatility?
Different sectors were “long” or “short” this crowd madness, which he labelled π, at different points in the cycle. (“Π” came from the Greek παράνοια, (paranoia). It conveyed the pleasing ideas not just of collective madness but circularity, running on a hamster wheel, Ouroboros eating its tail, and so on — all fundamental properties of the employment relationship.)
At its onset, “trad-fi” firms are short and potty start-ups long π. Eventually, the lunacy levels off, reality sets in and employment relations revert to the mean, whereupon the π curve flattens and then inverts.
If one could only match off these long and short exposures across the cycle, firms on either side of the bid could hedge their π exposure to the betterment of all.
In one of those ironies to whose martial cadence our lives keep bitter time, before he could monetise his idea, Barkley was laid off and, shortly afterwards, imprisoned for manipulating LIBOR.
“Employment derivatives” would thus lie fallow while he served out his porridge. But their time would come.
A chance encounter at a bar in West London
Some years later
As she neared her gin horizon, HR manager Anita Dochter embarked upon an elliptical disquisition to her old pal Cass Mälstrom. Dochter was agitated about the stream of defections from the sleepy mid-market broker where she worked. It was haemorrhaging hundreds of compliance and onboarding staff each month to venture capital-funded dotcom start-ups.
Mälstrom herself was one: a month earlier she’d been bid away from a workstream lead role in the firm’s client money compliance change management remediation programme and was now Co-deputy CIO of legaltech darling lexrifyly.
lexrifyly was flush with stupid amounts of cash and a great elevator pitch but as yet had no product to speak of, no business model, no customers and no obvious plan beyond maintaining a healthy burn rate. Poaching ex-colleagues turned out to be Mälstrom’s main function.
Her old chum was livid. “We need our people, Cass. They do productive things. You know, MIS reports. Steerco decks. Operational deep dives. Netting audits. Who will co-lead the client money remediation workstream if you take all our clunkers? Who will manage our risk taxonomy? Unless we pay your stupid rates, which we cannot afford to do —” at this point, Dochter fell off her stool briefly — “and give everyone free fruit, safe spaces 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 staff. You just need to show your investors you are on point doing fashionably insane things. That does not take actual staff. So stop taking ours.”
Mälstrom shrugged. “Well, how else am I meant to splurge away all this free money?” She lit a cigarette with a monkey.
Hunter Barkley, fresh out of gaol and making ends meet waiting tables, happened to be rostered on at Chez Guevara that evening.
Presenting them with the check and some after-dinner mints, he cleared his throat. “Forgive me, but I couldn’t help overhearing. If you” — he indicated Dochter — “don’t want to lose staff —
“I don’t.”
“— and you” — he looked at Mälstrom — “don’t need them —”
“She doesn’t.”
“— then why not hedge your respective employment rate risks with a swap?”
Mälstrom gaped. Dochter fell off her stool again.
Barkley dropped a slim document on the table.
Mälstrom prodded it. “What’s this?”
Barkley’s eyes glittered. “An NDA. Call me.”
The first employment rate swap
So was the very first “employment rate swap” conceived. For an initial period of three years, Dochter ’s firm 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 budget for an equivalent team — there was no such team, of course: this was the point — to Wickliffe Hampton.[1]
This way, Wickliffe Hampton had the cash required to preemptively bid back its restless staff, and lexrifyly could guilelessly piddle its investors’ cash against a wall without troubling the operating resiliency of the banking sector, or an HR department it did not currently have.
If this seemed like a bad trade for lexrifyly at the outset, it was not: firstly, cash was, Q.E.D. cheap, and lexrifyly didn’t care: what was money but fiat slavery? Secondly, Barkley’s forward curve models suggested that the looney bid could invert in several quite likely circumstances: a market crash, hawkish monetary policy or the sudden onset of incipient tech winter.
For these contingencies the employment rate swap was a natural hedge. While wide-scale redundancies and hiring freezes gripped the fintech sector, the boring old banking industry would box on as it always had. A fintech short π under an ERS would have a decent cashflow coming in to keep the lights on.
The “PIBOR” submission process
It was easy enough to quantify a bank’s wage bill since, once you controlled it for hysteria, it was more or less fixed. But what about the ever-changing hypothetical wage bill of a startup? How to gauge that in real-time? What was to stop a startup gaming the rate by pretending its preparedness to pay stupid money was lower than it really was?
An observable, objective measure of “prevailing startup insanity” approximating “π” was needed. Barkley supplied 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 and over kombucha martinis state publicly, in front of a panel of venture capitalists, how much they would be prepared to pay an underperforming settlements and reconciliations clerk to join them to “drive customer engagement”. They expressed this as a premium or discount to the equivalent value for the preceding day. The venture capitalists would vote by throwing money — literally, from a stack of bills on the table before them — at the “pitching” start-ups.
The BHCMA would weight the submissions by reference to the volume of cash the venture capitalists lobbed at each startup, trim the top and bottom estimates, average the remainder and compile and publish the trimmed arithmetic mean rate as the London Inter-Employer Offered Rate. Quickly “PIBOR,” as it became known, became the de facto measure of π and was soon factored into the “floating” leg of employment rate swaps as standard.
Credibility spread
Short counterparties would also be assigned a weighted average “credibility spread” over (or under) the prevailing PIBOR 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.
Though HR departments would force-rank staff to a curve graded against an internal 5-point scoring metric employee “alpha” could still be mispriced especially over time, as a result of mediocrity drift. Barkley adjusted his model for mediocrity “frown” — he called this “medioxity” — but the formal grade boundaries and other arbitrary “success criteria” of the HR model still still meant interdepartmental secondments were beset by diversity arbitrage and cheapest-to-deliver scandals, especially over quarter-end.
On the other hand reductions in force could be handled quantitatively by reference to the PIBOR forward curve rather than by business need or individual performance. This was not the last unintended consequence of the financialisation of the employment relationship.
Expansion
By this financial engineering Barkley had unwittingly created a tradable instrument out of an abstract benchmark. Due to their offsetting nature, one could trade “ERS” directionally, on abstract π without having a job, or even wanting one. These “synthetic” instruments were valuable for sectors exposed to the vagaries of the labour market even where not directly engaged in 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. Mediocrity and loyalty swaps, capital-protected RIF puts, diversity forwards, dynamic flight-risk hedging strategies and synthetic collateralised gender pay gap swaps. All these risks, and more, could be managed in the hypothetical without adjusting the physical staff roster at all.
ERS mis-selling
Banks even sold employment derivatives to their own employees, saving the bother of having to hedge themselves. There was an inherent conflict with these “self-referencing employment derivatives”: how could the very person presenting the risk to the organisation be the one to assume it? Especially as this was already embedded in the employment contract?
So began the sad chronicle of employment rate swap mis-selling. The scandal blew up when it emerged HR departments were being incentivised to “pi-hack” their employment derivatives portfolios by arbitrarily placing employees on performance management, covertly arranging other firms to bid them away or just peremptorily laying them off, leaving redundant staff holding twenty-five year, deep out-of-the-money employment rate swaps but no actual job to hedge with it. Being the sort of people who would sling their redundancy payoffs into Dogecoin these people were doubly exposed should crypto go titten hoch.
Though self-referencing employment derivatives are now prohibited in many jurisdictions, no-one was brought to book for these poor selling practices. Nevertheless, interests in ERS hedging waned shortly afterward, as other incidents came to light. Some were faintly comical: during the COVID-19 pandemic, a human resources trader at Wickliffe Hampton inadvertently opted for physical settlement by ticking the wrong box on a portfolio swap confirmation and had to deliver his entire HR department into a chain of patisseries that had just gone insolvent. At first, the team of thirty short-order cooks that turned up at Wickliffe Hampton’s London headquarters caused an uproar, but morale quickly markedly, no-one missed the performance appraisal process and the morning teas were pronounced by all to be “excellent”. In any case, there were fewer complaints than usual when, at the end of the year, there were donuts for everyone.
Conclusion
Employment swaps now may seem like just the last apocalyptic sign of an over-bought market, drunk on exuberance and about to hit the buffers, but the thinking behind them is sound, and their place in the history of over-the-counter derivatives should not be forgotten. They illustrate the power, potential and pitfalls of these “weapons of financial mass destruction”.