Chapter 1 Down in the Swaps

      If everything seems under control, you're just not going fast enough.

      —Mario Andretti (champion auto racer), Interview with Sam Smith

Red Light

       Thursday, November 6, 2014 (CFTC Headquarters, Washington, DC)

      “You cannot speak at SEFCON V.”

      I looked at my senior legal counsel, Marcia Blase, for a moment and let that sink in.

      “What? I thought that we were good to go? What happened?”

SEFCON, which had launched in 2009, was the annual Swap Execution Facility Conference. To many readers that must certainly sound like some obscure Wall Street gathering—and a boring one at that. But it was then the premier industry event focused on the important and growing category of trading platforms—swaps execution facilities—that were defined and mandated by Title VII of the Dodd–Frank Act. Dodd–Frank was the landmark financial industry reform legislation passed in the wake of the 2008 crash.¹ (More about this swaps business momentarily.)

      This conference was organized by a trade association I had helped form a few years before: the Wholesale Markets Brokers Association Americas (WMBAA). I was a past-chairman of WMBAA, stepping down in 2013 when the Obama Administration approached me about serving on the CFTC. Now, as a CFTC commissioner, I had tentatively accepted an invitation to return to SEFCON to address the audience from my new perspective as a regulator.

      “The White House will not grant you a waiver. They consider it non-essential. You can't speak at the conference.”

Swaps Breakdown

      Before I continue the story of SEFCON and the Obama White House, let's step back to answer a preliminary question: What are derivatives and swaps?

      Though unfamiliar and forbidding terms to some, derivatives and swaps are nothing less than the foundations of a stable and secure financial system. And, as I will explain later in this book, the advent of derivatives on cryptocurrencies has paved the way for a dramatic expansion and maturation of crypto as an entirely new investment asset class and subject of innovative financial services.

      Derivatives are tools that transfer risk among willing participants. They allow an individual or institution with risk they don't like or cannot bear to transfer that risk to someone who's capable of bearing it in return for some payment. We use this idea all the time in our daily lives. We constantly “hedge our bets” by offsetting our risk. For example, we might stretch to buy a condo near the seashore, but hedge our investment by renting it out to people all summer long to get some money back. We lower the risk of our investment in the condo by sharing it with others.

      History of Derivatives

Investors, farmers, and manufacturers have used derivatives for thousands of years to manage commercial and market risk. The classical philosopher Aristotle describes the Greek mathematician Thales making money off options contracts on olive presses as early as the sixth century BCE.² Derivatives allow users to guard against gains or declines in the value of underlying physical or financial assets, such as agricultural commodities, interest rates, stocks, bonds, trading indices, or currencies. They do this without requiring the user to buy or sell the underlying assets. In this sense, derivatives are a form of insurance, but one that does not require the insured to incur a loss in order to recover.

      American derivatives markets go back at least to the nineteenth century. The first were agricultural commodity futures markets in cities like New York, Philadelphia, Chicago, St. Louis, New Orleans, and Kansas City. These markets allowed farmers, ranchers, and producers to hedge production costs and delivery prices. That, in turn, helped ensure that American consumers could always find plenty of food on grocery store shelves.

Derivatives markets are one reason why American consumers today enjoy stable prices in all manner of consumer finance, from auto loans to home mortgages. Derivatives markets influence the price and availability of the energy used to heat homes and run factories. They also help set the interest rates borrowers pay on home mortgages and the returns workers earn on their retirement savings. Airlines use derivatives, too. The reason carriers are willing to quote us a fare for a ticket on a flight six months from now is that they are hedging their future fuel costs. The same is true for oil producers and refiners.

      Agriculture Futures

      Say I am a farmer and I own 444 productive acres—the national average for a family farm. Assume further that I rotate between soybeans and corn, which is common. To keep my farm in business and my bills paid, I need to know a lot. I know my soil and the effects of various weather patterns on my crops. I know what my farmhands cost and what my gasoline costs. I know what my seed costs. I know what my fertilizer costs. What I don't know, though, is what the price is going to be for soybeans come November. So, I add up all the costs for the year—the farmhands, the tractor, the gasoline—and that comes to $6.75 a bushel. But when I go to market, I know from experience that soybean prices could range anywhere from $6.00 to $9.50 per bushel. Those varying prices could spell the difference between windfall profits and bankruptcy.

      So how do I transfer that risk to somebody who is willing to bear it? Well, what I can do is enter into a contract on the futures market. I lock in $7.75 a bushel for at least half my production. That way I know that if there is too much supply and bushels are selling at less than my $6.75 cost, I'm going to make at least a dollar more and keep my farm solvent. Of course, I'm giving away some of my upside if the price goes up to $9.50 a bushel. But at least I'll make those profits on the other half of my production. I'm trading risk for certainty.

Global trade also depends on derivatives. Without markets to hedge the risk of fluctuating currency exchange rates, manufacturers and growers would be afraid to accept any currency for their exports other than their own. Without markets to hedge the risk of differing interest rates around the globe, banks and borrowers would be reluctant to transact cross-border loans. Without derivatives, goods, services, and capital would not