The fin de siècle Dismantling of the

Economy’s Legal Infrastructure

By Carolyn Sissoko

August 27, 2009

1
I Dismantling the Law

One aspect of the recent financial crisis has not received as much attention as it deserves: the
recent dismantling of the centuries-old legal structure that governed derivative contracts. In
early 19th century Britain a derivative contract on railroad stock was legal, whereas the same
contract on Bank of England shares was not. The Gaming Act of 1845 rationalized this situation
by voiding all derivative contracts that fell within the definition of a wager. A test commonly
used to determine whether or not a derivative was a wager looked at the intended method of
settlement: if the derivative was to be settled by delivery of the underlying asset it was not a
wager, whereas typically derivatives that were settled in cash were wagers. In addition, the
common law definition of a wager exempted from the Gaming Act any contract where one party
could demonstrate that the contract was being used to hedge genuine economic risk. Similar
legal standards were implemented in the United States. To finesse this legal situation where cash
settled derivatives were void, members of the various Exchanges in both Britain and the US
purchased offsetting contracts and cleared them. By the early 20th century, exchange traded
derivatives were held to be legally enforceable. In both countries, however, derivatives that were
traded over-the-counter, were settled in cash and were not bona fide hedges fell under the
jurisdiction of gambling law through most of the 20th century and were void.

These legal norms comprised an important part of the financial infrastructure that underpinned
economic growth in Britain and the US from the second half of the 19th century through the last
decades of the 20th century. The laws affecting financial contracts began to be changed in the
1990s and by early in the 21st century, the conscious decision by 19th century legislators and
jurists to void over the counter derivative contracts that did not serve an insurance purpose had
been reversed.

This dramatic change in financial law has gone largely unnoticed because of a very recent
change in the way that society thinks about financial contracts. In 19th century Britain the fact
that many of the derivative trades that took place on the Stock Exchange were wagers was a
universally accepted truth. By contrast the Wikipedia entry on Gambling states: “Some
speculative investment activities are particularly risky, but are still usually considered separately
from gambling” and cites “securities derivatives, such as options or futures” as examples.1

A Brief History of Derivatives Contracts

Contracts for future delivery are probably as old as trade itself.2 Indeed, in communities with
limited access to money, trade typically involved commitments to future transactions.3 Thus, it
should come as no surprise that forward contracts developed simultaneously with commodity
markets. Once an economy was monetized, cash settlement of the forward contract was a minor
innovation. Stock and bond markets only arise in monetized economies, and the evidence

1
Viewed 1/12/2009.
2
Postan in his essay “Credit in Medieval Trade” (Economic History Review, 1(2) 1928, pp. 243 – 244) finds that
contracts for future delievery were common in Medieval Europe. Also see: Ernst Weber, “A Short History of
Derivative Security Markets” (June 2008). Available at SSRN: http://ssrn.com/abstract=1141689
3
Legal records from feudal manors in England indicate that there were settlement days, where the previous months’
transactions are formally offset and the balance is settled. Source?

2
indicates that cash-settled forward contracts on securities developed more or less
contemporaneously with the markets themselves.

In short, derivatives are as old as commodity and securities markets. In 16th century Europe the
uncertain flow of precious metals from the Americas meant that the finance of international trade
resulted in currency risk. And we find accounts of active markets in currency futures that date
back to 1542.4 The Dutch stock market was founded at the start of the 17th century and
derivative contracts are found in the earliest records of those markets.5 Option contracts (and the
leverage they involve) may have played an important part in the Dutch Tulipmania of the 1630s.6
The first work on speculation and hedging techniques, Confusion de Confusiones, was published
in 1688 in Amsterdam and described futures, options and trading on margin in detail.7

1688 was also the date of the Glorious Revolution which brought William of Orange and a host
of Dutch financiers to England. By the start of the 18th century London, too, had a flourishing
stock exchange, where stocks and government debt both traded and the full range of derivatives
was available. Thus, in England interest rate derivatives date back to the 18th century.

In 18th and 19th century Britain, derivatives were called time bargains or time contracts.8 The
term “time bargain” refers to the fact that derivatives are financial contracts, whose value
depends on the future value of an asset (or other item) that is called the underlying. Thus the
term “time bargain” distinguishes derivative trades from spot trades that depend only on the
current price of the asset.

In England the 1734 Stockjobbing Act prohibited trade in derivatives on securities that were not
settled by delivery of the underlying. In 1766, however, Adam Smith observed that time
contracts on stock were still traded, even though “the law gives no redress” for failure to pay. He
noted that reputation effects keep the market going: “People who game must keep their credit,
else nobody will deal with them.”9 By 1844 the privately enforced market in derivatives
contracts on the British Funds was so successful, that the Select Committee on Gaming decided
that there was no need for judicial and legal enforcement of speculative derivative contracts at
all.

The history of derivatives in the United States follows a similar pattern. In 1792 the New York
Stock Exchange was founded, and by 1829 a Stockjobbing Act was passed to prohibit derivative
trades that were not settled by delivery of the underlying. The Stockjobbing Act was repealed in
1858, and by the 1870s there was an active market in stock options with prices quoted in the

4
Cristoval de Villalon (1542) quoted in Weber, op. cit.
5
Van Dillen (1935) quoted in Weber, op cit.
6
Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,
McGraw-Hill Professional, 1999, p. 2-3 and Earl Thompson and Johnathan Treussard, “The Tulipmania: Fact or
Artifact?” UCLA mimeo 2002, http://www.dklevine.com/archive/thompson-tulips.pdf.
7
Larry Neal, The Rise of Financial Capitalism, 1990, Cambridge U Press, p. 16. Also see Weber, op cit. p. 15.
8
Report of the Select Committee on Gaming, House of Commons, 1844. This Committee investigated the
consequences of the Stockjobbing Act of 1734 that explicitly prohibited option contracts and certain forward (or
futures) contracts. The generic term used for these contracts was “time bargain” or “time contract.”
9
Smith (1766) quoted in Weber op cit. p. 22.

3
newspaper.10 This active market disappeared in the late 1870s, a fact that Kairys and Valerio
(1997) attempt to explain by claiming that prices disadvantaged investors. It is possible that
there is a more prosaic explanation for the collapse of the market: cash settled derivative
contracts were held by the courts to be unenforceable contracts under the law in Irwin v. Williar,
which was decided by the Supreme Court in 1884 on the basis of events that took place in 1877.

As in England, however, the legal status of derivatives on securities did not put an end to the
trade in them. In the 1920s option pools, where a group of investors built up a large position in
low-priced call options on a firm – often with the help of the company itself or of its officers –
and then preceded to manipulate the firm’s share price, were extremely common. For this reason
in the 1930s options were almost outlawed. However, the head of the Put and Call Brokers and
Dealers Association (PCBDA) convinced Congress that options could be used to transfer risk.
Thus the SEC was given jurisdiction over the options industry by the Securities and Exchange
Act of 1934 and the PCBDA became a self-policing entity subject to the SEC’s authority. The
next year the Chicago Board of Trade was authorized to establish an options exchange, but it was
only in 1973 that trade opened on the Chicago Board Option Exchange.11 Prior to the
establishment of the CBOE, option trading on secondary markets was very limited.

While there were active markets in stock options in the 19th century, they were much more
limited than the option markets with which we are familiar today. Options sold in New York in
the 1870s were American, close to at-the-money and had one month to maturity; in London at
the turn of the century options were European, at-the-money and had one month to maturity.
The fact that in or out of the money options were rarely traded is an indicator that secondary
markets in options were not very deep.

Nowadays options are regularly traded in or out of the money and with more than a year to
expiration. Exchange trading of options facilitates an active secondary market in options,
allowing any individual with a brokerage account to be an option trader. Thus while we can be
confident in the knowledge that forward, futures and option contracts on securities have been
traded over the counter since the early days of securities markets, we must also acknowledge that
a broader range of products trade on modern derivative markets and that markets are far deeper
than they were in the past.

In fact the last quarter century has seen an unprecedented boom in derivatives contracts and in
the structured products that are based on them. Every major investment bank has a division that
focuses on structured finance or on the use of derivatives to create new investment products out
of old-fashioned debt, equity and money market instruments. Many reasons have been proposed
for this sudden wave of financial innovation including the common use of derivative pricing
algorithms and the growth of computing power that enables traders to use a model to price
complex products. I suspect that the reason for this growth is more fundamental: a change in the
10
Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,
McGraw-Hill Professional, 1999 documents a call ticket dated 1875. Joseph Kairys and Nicholas Valerio, 1997,
“The Market for Equity Options in the 1870s,” Journal of Finance, 52(4), pp. 1707-23.
11
Geoffrey Poitras, 2002, Risk Management, Speculation, and Derivative Securities, Academic Press, pp. 42 – 46
and Options Institute (Chicago Board Options Exchange), Options: Essential Concepts and Trading Strategies,
McGraw-Hill Professional, 1999, pp. 6 – 9. The CBOE was created as a separate organization so that the CBOT
would not have to answer to two different regulators, the CFTC and the SEC.

4
way that society thinks about financial contracts has led to a change in the legal status of over the
counter derivatives contracts.

The changing view of financial contracts

In 19th century Britain time bargains were often settled by paying cash rather than actually
trading the underlying.12 A cash settled derivative contract was called a “contract for difference”
and was considered a wager.13 Legal records indicate that these contracts were common. Thus,
when England’s House of Commons established a Select Committee in 1844 to study the state of
the law related to gaming, the fact that the wagers being made on the Stock Exchange lay under
the Committee’s purview was assumed by witnesses and Committee members alike.14 Police
Commissioner Daniel Harvey when asked about gaming houses in the City of London, responds:
“As to gambling-houses, in the larger sense of the term, I know of none, except the Stock
Exchange may be so considered.” When questioning Mr. John Bush, the Chairman opens with:
“Have you any knowledge of the system of gambling which is understood to be going on in the
Stock Exchange?” And the Report of the Committee itself explicitly addresses time bargains.
Thus, it was clearly the intent of legislators that the Gaming Act of 1845, which enacted the
recommendations of the Committee by voiding all gambling contracts, be applied by jurists to
transactions on the Stock Exchange that met the definition of a wager.15

The same attitude toward speculative financial contracts is found in any of a wide variety of
early 20th century American legal texts.16 I will cite the text of Mack and Hale’s Corpus Juris
(1922).17 Options and futures contracts are covered in the section titled Gaming. After defining
Futures, the authors note: “The term futures has grown out of those purely speculative
transactions, in which there is a nominal contract of sale for future delivery, but where in fact
none is ever intended or executed.” In the subsection on the validity of gambling transactions,
the authors observe: “If under the guise of a contract of sale, the real intent of both parties is
merely to speculate in the rise or fall of prices, and the property is not to be delivered, but at the
time fixed for delivery one party is to pay the other the difference between the contract price and
the market price, the whole transaction must be considered as a wager and invalid.” The validity
of option contracts is also discussed and the same conclusion is reached: if the intent of the
contract is that differences will be paid then the contract is “a wager and void.”

12
This was also true in 17th century Holland. Archetypically it appears that cash settled derivatives markets almost
always develop alongside stock markets.
13
The modern usage of “contract for difference” refers specifically to a forward contract that is settled in cash.
14
Report of the Select Committee on Gaming, House of Commons, 1844. See the report itself (p. v) and in
particular the testimony of Police Commissioner Daniel Harvey and Mr. John Bush. Many other witnesses mention
the Stock Exchange. (The Report has an excellent index.)
15
Note that a wager was not formally defined under common law until 1892. In Carlill v. Carbolic Smoke Ball Co.
it was determined that a wager “involves an agreement between two people that upon the determination of an
uncertain event or fact, one shall receive from the other ‘a sum of money or other stake’.” (The Modern Law of
Contract, Richard Stone, Routledge Cavendish, 2005, p. 374.)
16
See for example Judicial and Statutory Definitions of Words and Phrases, West Publishing Company, 1904, p.
5002 or Legal Definitions: A Collection of Words and Phrases as Applied and Defined by the Courts,
Lexicographers and Authors of Books on Legal Subjects, Benjamin W. Pope, Callaghan and Co., 1920, p. 1082.
17
Corpus Juris: Being a Complete and Systematic Statement of the Whole Body of the Law as Embodied in and
Developed by All Reported Decisions, William Mack and William Benjamin Hale, American Law Book Co., 1922.
Quotes from pages 992, 1055 and 1061 respectively.

5
Overall the Corpus Juris makes it clear that what distinguishes a valid financial transaction from
one that is void under gambling laws is the intent to deliver the underlying commodity or asset.
This standard was established by the US Supreme Court in Irwin v. Williar (1884), where the
Court held that a contract with no intent to deliver is an act of speculation and therefore a wager
under the law.18

Turn of the century legal scholars drew a clear distinction between investment and speculation.
19th century jurists recognized that speculative transactions are zero-sum – whatever is gained by
one party is lost by the other – and thus, by definition, unproductive.19 While speculation was
often tolerated, it was generally considered an activity too trivial to merit the expenditure of a
court of law’s time and resources.20 Investment contracts, on the other hand, were viewed as
productive and important elements of a healthy economy. Thus, it was entirely appropriate for
the court’s time to be spent adjudicating disputes related to investment.

As noted above, the main criterion used to distinguish a speculative contract from an enforceable
contract was the delivery of the underlying asset. Thus, common law in the 19th century set a
standard: only financial contracts that were closely tied to transactions in the real economy were
enforceable under the law.21

By contrast Britain’s Financial Services Act of 2000 (FSA) defines “investment” to include a
wide variety of common investments, futures, options and “any right or interest in anything
which is an investment.”22 Thus, swaps and virtually all other derivatives are considered
“investments” under British law, because one party always has a right to the income stream from
an “investment” – even though tomorrow that right may turn into an obligation. As was
mentioned above, this view of investments has entered into the Wikipedia entry on Gambling.

If Britain’s Financial Services Act and Wikipedia are representative of the modern understanding
of the word “investment,” then Black’s Law Dictionary (2004) is out of date. It reads:
Investment. 1. An expenditure to acquire property or assets to produce revenue; a capital outlay.
2. The asset acquired or the sum invested.

Under this definition, a derivative contract where there is no expenditure by either party at the
outset cannot be considered an investment. Neither forward contracts, nor swaps meet the terms
of the definition, and futures contracts which require only the posting of a small margin – which
will be returned, if the contract does in fact produce revenue instead of expending it – probably
aren’t investments either.

18
Cited in Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 714 – 715.
19
See, for example, the quote from the Supreme Court of Pennsylvania (1867) in Lynn Stout, “Why the law hates
specultators,” Duke Law Journal, 48(701), p. 717, n. 57.
20
Report of the Select Committee on Gaming, House of Commons, 1844, p. vi.
21
In this view, the fact that stocks and bonds finance real economic activity directly means that derivative
transactions that settle by delivery of stocks or bonds are closely tied to the real economy.
22
Financial Services Act 2000, Schedule 2, Part II.

6
It appears that currently the meaning of the word “investment” is in transition. On the one hand,
the traditional meaning, which would probably be acceptable to our 19th century forebears, is still
in use. This traditional definition requires the expenditure of an initial sum in order to receive in
exchange a revenue stream.

On the other hand, in certain circumstances a new meaning of the word has developed. Under
the FSA’s definition, an investment is not just any financial asset, but can also include financial
liabilities. A swap, for example, requires no initial outlay of funds by either party, but typically
becomes a liability for one party and an asset for the other depending on the behavior of market
prices after the contract is signed. Because from the point of view of one party to the contract, a
swap can morph daily from asset to liability and vice versa, considering it an “investment”
clearly adds a new dimension to the meaning of the word.

Our 19th century forebears would easily have recognized the potential economic role of a swap:
when paired with another asset a swap can play the role of insurance. However, in the absence
of such an insurance role, they would never have accepted that a swap was an investment
contract; on the contrary, they would have called it speculation.

In short, in modern usage we find that the distinction between speculation and investment is
eroding. For this reason, it is not surprising that the presumption in the 21st century is that
financial contracts are not subject to gambling laws, or that the opposite presumption prevailed
in the 19th century.

A brief review of early derivatives law

The regulation of derivatives in Britain started in 1734 when the Stock-jobbing Act explicitly
voided all option contracts, cash settled forward contracts, short sales and contracts involving a
short forward position. The Act also imposed fines as high as £500 on derivative transactions.
While the harsh penalties enacted clearly had the intent of closing down derivatives markets, a
century later juries apparently refused to impose the fines. By the middle of the 19th century the
British market for securities based derivatives had bifurcated: those that referenced newer shares
and foreign stocks were legal contracts, whereas those referencing British government debt and
the oldest names on the stock market were illegal and unenforceable. In 1844 the Select
Committee on Gaming considered the incoherent state of the law, determined that the informal
penalty of expulsion from the Stock Exchange was sufficient to support a substantial market in
derivatives and concluded with a recommendation to void all time bargains that were in fact
wagers.23 Thus, the Gaming Act of 1845 simplified the legal structure for derivatives by making
all wagers void.

The extra-legal status of many of the trades that took place on the Stock Exchange continued for
decades. For example, after an episode of boom and bust in bank stocks (which coincided with
the failure of several banks) Leeman’s Act was passed in 1867 with the goal of prohibiting short
sales in bank stocks. The law stated that all bank stock transactions were void, unless the
specific shares traded were identified by registration number or owner. Apparently the members

23
Report of the Select Committee on Gaming, House of Commons, 1844. On the derivatives markets supported by
the penalty of expulsion from the Stock Exchange, see in particular questions 866 – 872 and 2555 – 2570.

7
of the Stock Exchange dealt with this law, just as they had dealt with the Stockjobbing Act a
century earlier: they ignored it. As long as members were trading with each other in bank
shares, no problems arose, but at least one court case makes it clear that non-members were
willing to void their obligations on the basis of documents without the legally required
information.24

By 1878, the courts held that the transactions on the Stock Exchange were not settled in cash, but
instead involved the clearing of legal transactions that offset each other.25 Thus transactions on
the Stock Exchange were not voided by the Gaming Act. In a bit of a legal twist, however, in the
case of a bankrupt member of the Stock Exchange the courts also held that the Stock Exchange
assignee who resolved the transactions of the defaulter by taking payment in cash from his
debtors on the Exchange and allocating proceeds in cash to his creditors on the Exchange had no
obligation to turn the proceeds over to a bankruptcy trustee. Effectively the settlement by the
Stock Exchange of the defaulter’s transactions did not involve an assignee receiving payments
that were debts under the law, but instead the assignee received the payments per the rules of the
Stock Exchange and thus had to act according to those rules. In short, while Stock Exchange
transactions were not void, they were also not subject to resolution in bankruptcy court.26

As one might expect, many of the principles that were established under British law were also
applied by courts and legislatures in the United States. In general, when the intent of a forward,
futures or option contract was to settle by delivery of the underlying asset or to insure against
losses on an existing position, the contract was valid and, when the intent of the contract was to
settle in cash, the contract was a wager and void.27

The US treatment of exchanges differed in some respects from that of Britain. When the US
Supreme Court recognized the validity of exchange-traded derivatives in 1905, it did so not only
on the basis that offsetting positions are distinct from cash payment, but also because: “It seems
to us an extraordinary and unlikely proposition that the dealings which give its character to the
great market for future sales in this country are to be regarded as mere wagers.”28 This ruling
made possible the passage of “bucket shop” laws, which criminalized establishments that

24
The Law Relating to Betting, Time-bargains and Gaming, George Herbert Stutfield, Waterlow & Sons, 1884, p.
99.
25
“ ‘Contracts on the Stock Exchange are never for the receipt or payment of differences. All contracts, etc., are
real transactions for cash or for a day named, contemplating the actual transfer or delivery … and which transfer or
delivery can only be rendered unnecessary by a new and equally real bargain on the one part to accept and pay for
on the same day, and on the other part to transfer or deliver an equivalent amount of the same stock.’ It is then
further stated that if a member having, say, bought stock which he was unwilling or unable to take up, he balances
the transaction by selling a similar amount of (but not the identical) stock for the same settling day for which the
bargain was originally made, so as to enable that particular transaction to be written off an balanced.”Thacker v.
Hardy (1878) as quoted in The Law Relating to Betting, Time-bargains and Gaming, George Herbert Stutfield,
Waterlow & Sons, 1884, p. 84.
26
Ex parte Grant re Plumbly (1880) is explained in The Law Relating to Betting, Time-bargains and Gaming,
George Herbert Stutfield, Waterlow & Sons, 1884, p. 78 – 79. This precedent was first set by Nicholson v Gooch
before the repeal of the Stockjobbing Act in 1860. In Nicholson v Gooch the courts found that, because most of the
bankrupt’s Stock Exchange transactions were void, his legal creditors had no claim to them.
27
Anglo-American Securities Regulation: Cultural and Political Roots, 1690-1860, Stuart Banner, Cambridge
University Press, 2002, p. 182.
28
Cited in Lynn Stout, “Why the law hates specultators,” Duke Law Journal, 48(701), pp. 720.

8
claimed to sell derivatives, but in practice were bookmakers taking bets on the performance of
companies and commodities listed on the exchanges. Prior to the formal recognition of
exchange-traded derivative transactions as legal, it was difficult to regulate bucket shops without
adversely affecting trade on the exchanges as well.

Thus in early 20th century America, financial contracts that were directly tied to the real
economy and contracts that were traded on exchanges were legal. Trade in financial contracts
that did not meet these criteria was unenforceable in a court of law.

The Commodity Exchange Act of 1936 codified this approach to derivatives for a specific group
of commodities. A contract for future delivery is legal if either (i) it is traded on an organized
exchange or (ii) the intent is to settle the contract by transferring the underlying asset. This law
renders over-the-counter, cash-settled contracts for future delivery illegal.29

The codification of common law as it applies to derivatives was further advanced by the revision
of the Commodity Exchange Act in 1974. The revised law covers contracts for future delivery
on all goods (except for onions), articles, services, rights and interests, and establishes the
Commodity Futures Trading Commission (CFTC) to enforce the law.30

Note that the Commodity Exchange Act regulates all “contracts for future delivery.” As the term
“futures” was already in common usage and the law explicitly creates an exception for forward
contracts settled by delivery of the commodity, it is clear that the intent of the law was to address
time bargains (or derivative contracts) in general. Up until at least 1987, the General Counsel
and Commissioners of the CFTC believed that not only futures, but also swaps and options lay
under their purview.31 In fact, according to Brooksley Born “it was not a legitimate legal
position” to claim that the CFTC did not have jurisdiction over over-the-counter derivative
markets in 1998.32

If (i) the term “contracts for future delivery” is understood to include all derivatives, including
forward contracts, futures, options, swaps and the hybrid and structured instruments based on
them, and (ii) there is no penalty for trading in over-the-counter, cash-settled derivatives (i.e.
they are simply void), then the Commodity Exchange Act of 1974 would serve to reinforce the
fundamental principles of law that were derived in the 19th century.

Modern derivatives law

As noted above, in Britain the Financial Services Act establishes an extremely broad definition
of investments: it appears that all over-the-counter, cash-settled derivatives are defined in the
FSA to be investments. The FSA also states explicitly that as long as an investment or an
investment related contract is entered into by one party “by way of business,” that contract will
29
Lynn Stout, “Why the law hates specultators,” Duke Law Journal, 48(701), pp. 722 – 3.
30
Lynn Stout, “Why the law hates specultators,” Duke Law Journal, 48(701), pp. 722 – 3. An explicit exception is
made for financial securities which are subject to the jurisdiction of the SEC.
31
Mark Young and William Stein, 1988, “Swap Transactions Under the Commodity Exchange Act: Is
Congressional Action Needed?” Georgetown Law Journal, 76, pp. 1917 – 1947.
32
Rick Schmitt, “Prophet and Loss,” Stanford Magazine, March/April 2009,
http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html

9
not be voided by gambling laws.33 Thus in Britain the Financial Services Act of 2000 dismantles
the traditional legal approach of treating only derivatives that are closely tied to the real economy
as valid contracts.

In the US, the dismantling of the traditional approach to derivatives took place over the last two
decades. In 1992 a law was passed permitting the CFTC to exempt contracts from its
jurisdiction and in 1993 swaps were exempted by the CFTC from the Commodity Exchange Act.
In 1998, however, the CFTC put out a Concept Release which raised the possibility that the 1993
decision would be reevaluated. The CFTC, however, did not have the support of other financial
market regulators who instead proposed that the Commodity Exchange Act be rewritten to
severely circumscribe the jurisdiction of the CFTC.34

Thus, in December of 2000 the Commodities Futures Modernization Act was passed as part of
the 2001 federal budget appropriations. This law removed swaps and hybrid instruments from
the jurisdiction of the CFTC. Under the Act, transactions between Eligible Contract Participants
are no longer subject to the provisions of the Commodity Exchange Act which voided over-the-
counter, cash-settled contracts for future delivery. It also preempted the application of state
gambling and bucket shop laws to over-the-counter derivatives. In short, by making
unenforceable contracts enforceable the Commodity Future Modernization Act of 2000
completely changed the legal framework which had shaped the financial system of the United
States for nearly two centuries.

Releasing finance from the constraints of the real economy

19th century legislators and jurists crafted a carefully considered approach to derivatives. The
principle underlying this approach was that financial contracts are legally enforceable only when
they are tied to the real economy. For this reason, if (i) the intent is to deliver the underlying
asset or (ii) the contract insures one party against an existing risk, the contract plays a role in
distributing real economic risk and is legally enforceable.35 On the other hand, contracts where
both parties were speculating on some future event – such as the price of an asset – were
considered wagers and void.

By establishing a clear distinction between speculative derivatives and those that served an
economic purpose and enforcing only the latter, 19th century jurists created a legal framework in
which finance was forced to address the needs of the real economy. By contrast in the 21st
century, the distinction between speculation and investment has eroded. All financial contracts
are enforceable, whether or not they contribute to the real economy – and finance has been freed
from the bonds that held it in check for almost two centuries.

33
Financial Services Act 2000, Section 412
34
President’s Working Group on Financial Markets Report, “Over-the-counter Derivative Markets and the
Commodity Exchange Act,” November 1999
35
The latter is a common law standard. Because derivatives were typically voided under gambling laws, the ability
to demonstrate that the contract indemnified one party against a loss sufficed to prove that the contract was not a
wager. See also Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 718 – 9.

10
II Early financial history and the development of fiat money

In section one we demonstrate that 19th century law required financial contracts to serve the real
economy. Of course, there is a financial history that predates the 19th century. Here, too, we
find that constraints were established to ensure a close tie between the real and the financial.

Constraints on finance prior to the 19th century

As the middle ages were coming to a close Europe developed a financial instrument called the
bill of exchange that was managed by a network of wealthy merchant bankers. In its initial form
the bill of exchange was used to finance international trade between Europe’s leading cities. The
bill was a short-term debt contract that was payable in a foreign country. Clearing mechanisms
enabled trade in these bills to minimize the transport of gold and silver across Europe.

In the sixteenth century the bill of exchange evolved into a very different instrument.
Endorsement allowed bills to circulate from hand to hand before being redeemed, and domestic
bills became the norm in highly developed commercial economies. Local bankers managed local
networks and stood ready to discount bills before they were due. Thus, a tradesman with a local
bank account could write a bill in the name of a supplier, who could then choose to hold the bill,
endorse the bill over to a creditor of his own or cash it – less a discount – at the bank. The bill
was a form of commercial paper that was endorsable and effectively allowed banks to underwrite
a system of trade credit for the local community. The result was that trade in urban economies
began to take place on the basis of a paper monetary system that was supported by a network of
banks.

In order for the system to work standards had to be put into place to prevent the local tradesmen
from writing too many bills. In practice a single principle was used to regulate this credit
system: A bill was valid only if it was issued in exchange for goods. Bills that were written in
the absence of a real exchange were described as “fictitious” or “accommodation paper.” Any
tradesman who was caught issuing fictitious bills was considered a fraud and excluded from the
financial network. Suspicion of such fraud could also derail a tradesman’s career.

The principle that bills were valid only when they were issued in exchange for real goods is now
known as the Real Bills Doctrine. This doctrine was the standard our early modern ancestors put
in place to ensure that finance served the needs of trade. It had the advantage of being applied at
the individual level, creating a completely decentralized means by which the issue of financial
paper could be controlled.

Nowadays the real bills doctrine is famous because it played an important part in the debate over
monetary policy that took place in England in the early 19th century. The Currency School
argued that the Bank of England should be constrained to issue bank notes in an amount that did
not exceed the amount of gold it held in its vaults, while the Banking School argued that the real
bills doctrine was sufficient to control the money supply and that the Bank needed to have the
flexibility to issue an indeterminant quantity of bank notes when discounting real bills. It’s
worth noting that the real bills doctrine was so fundamental to the 18th and early 19th century
concept of financial stability, that no one questioned the necessity of adhering to the doctrine.

11
The issue in the debate was whether or not the real bills doctrine alone was sufficient to ensure
financial stability.

The denouement of this controversy took place when the Bank Charter Act of 1844 was passed.
This was effectively a compromise. Only the Bank of England was allowed to issue bank notes
and the Bank’s issue was fixed by the amount of gold in its vaults; however, the Act was subject
to suspension by executive order. In practice, this meant that the Bank of England’s note issue
was restricted – unless economic circumstances required a greater supply of notes. The Act was
temporarily suspended in 1847, 1857 and 1866.

The 19th century evolution of the financial system

In the meanwhile, the British economy was steadily outgrowing the real bills doctrine itself. By
the start of the 19th century in England the system of domestic bills had evolved into acceptance
finance. A country tradesman who regularly shipped his wares to a London middleman for sale
would draw on his account with the middleman when making purchases in his own local
community. The tradesman would write a bill drawn on the London middleman to pay his local
supplier. The supplier would go ahead and circulate the bill through endorsement. However,
until the bill was discounted at the local bank, sent by the banker off to his London
correspondent for settlement and formally accepted by the London middleman as an obligation,
there was no certainty under the law that the middleman would pay.36

In short, acceptance finance was a prototype for the checking account system that would develop
decades later – just like a checking account system it required that (i) bad bills or checks be
passed infrequently and (ii) middlemen or bankers could be relied on to honor their obligations.
When one recognizes the sophistication of the financial system in Britain at the turn of the 19th
century, one begins to understand why Henry Thornton considered the “science” of credit to be
the fundamental source of British growth at the time.37

Now here is the question: Is the bill drawn by the country tradesman on the London middleman
a real bill or a fictitious bill? Assuming they have an ongoing relationship is there anything
wrong with a middleman accepting the bill before he has received a delivery of goods? Is there
anything wrong with a middleman extending an overdraft to a tradesman? It was probably
inevitable that the practice of acceptance finance broke down the cultural barriers that had
supported the real bills doctrine. Henry Thornton’s Paper Credit makes it clear that by the early
years of the 19th century, some British bankers were beginning to realize that a “good bill” could
be backed by nothing more than an individual’s personal credit.

Legal cases demonstrate that the use of accommodation paper was growing – and becoming
more acceptable – through the first decades of the 19th century.38 The Banking Act of 1844
started a different trend: banks that were no longer allowed to issue bank notes found another

36
James Rogers, The Early History of the Law of Bills and Notes, Cambridge University Press, 1995, pp. 113, 171-
173, 188-189.
37
Henry Thornton, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, 1802, pp. 175 –
176.
38
James Rogers, The Early History of the Law of Bills and Notes, Cambridge University Press, 1995, chapter 10.

12
way to create money, the checking account. These two trends combined to create a new
financial system centered around banks as the arbiters of credit.

The 19th century witnessed a transition from a decentralized system of paper money that was
controlled by adherence to the real bills doctrine to a more complex system in which short-term
monetized credit was allocated by banks and an ever growing number of firms had access to
long-term credit markets. As was demonstrated in Chapter 1, the growth of long-term credit
markets and the derivative markets related to them led to the development of a legal doctrine that
rendered purely speculative transactions invalid under the law.

At the same time a new approach had to be found to control the growth of the new monetary
system based on checking accounts. The Banking Act of 1844 had been a first effort at direct
control of the money supply. It was unsuccessful in many ways: In the first quarter century after
it was passed, it had to be suspended three times in order to protect the economy from the
ravages of liquidity crises. And the growth of checking accounts effectively neutered the Act.

In the meanwhile, however, the Bank of England had a discovered a new tool for controlling the
money supply. In the 18th century the Bank’s discount rate had remained fixed at 5%. As a
consequence in normal times competing banks took most of the trade, and the Bank’s discount
business was relatively small. In a liquidity crisis, however, the Bank’s discounts would increase
astronomically for a few days or even weeks only to fall back to normal when the panic had
eased.

In the first half of the 19th century a major concern of the Bank was the maintenance of its gold
reserves. Thus, the outflow of gold that was associated with crises and strong demand for
discounts at the Bank caused concern. It didn’t take long for the Directors of the Bank to realize
that by raising the discount rate, they could moderate the outflow of gold.39 In the 1820s Bank
Rate, or the discount rate of the Bank of England, started to be used as a policy tool. By the
middle of the century Bank Rate was the principal policy tool that the Bank used to control the
flows of gold to and from the Bank and to moderate the growth of credit and of the money
supply.

The genesis of fiat money

England developed a paper monetary system in the late 18th century. The monetary system was
not uniform across the country. In commercial regions a large fraction of the circulating
currency took the form of domestic bills. Local bank notes were often an important part of the
currency too, especially in agricultural districts. Bank of England notes were issued in large
denominations and were important for settling interbank accounts, but circulated very little in the
countryside.

This state of affairs changed dramatically in 1797. The finance of the Napoleonic Wars had put
an enormous strain on the financial system and the Bank of England risked running out of gold.

39
In fact, this obvious possibility had been raised in 1802 by Thornton who makes it clear that usury laws interfered
with the operation of this mechanism. Paper Credit, p. 254.

13
The solution was the suspension of the convertibility into gold of the Bank of England note.
This suspension lasted for almost a quarter of a century.

As the local banking networks had relied through their London correspondents on the gold
reserves of the Bank England in order to meet the demands of their own customers, it was no
longer possible for local banks to pay out their notes in gold upon request. To resolve the
settlement problem in the countryside, the Bank of England began to issue notes in small
denominations – making it possible for the local banks to pay out Bank of England notes instead
of gold.

Thus, at the turn of the century the British economy shifted very smoothly from a gold standard
to a fiat money standard. During the war the economy experienced a moderate level of inflation
with the result that when the war finally ended in 1815 it was not immediately possible to resume
convertibility of the Bank of England note into gold at the rate that prevailed in 1797.
Policymakers, however, were committed to resumption at the original exchange rate. Thus, in
the years following the Napoleonic Wars the British economy was put through a severe recession
and in 1821 convertibility of the Bank of England note was restored.

Despite the fact that gold was now readily available, country banks continued to settle their
obligations in Bank of England notes with frequency for the simple reason that Bank notes were
accepted by almost everyone. Bank of England notes displaced gold as a means of settling
trades, because they were in practice “good as gold”.

Thus, the foundations of a modern banking system were laid in 19th century Britain. Paper bank
notes were universally accepted in final settlement of debt. The banking system offered
checking accounts to the general public and short-term credit to those that met the criteria of the
bankers. And finally the whole system was moderated by the Bank of England’s control over the
short term interest rate on bills discounted at the Bank. The great 20th century innovation would
be the shift to a true fiat money standard with no convertibility of bank notes into any kind of
real asset.

Conclusion

In early modern Europe, the real bills doctrine served as a decentralized means of limiting the
growth of paper money and of tying credit issued by the financial system to the real economy.
However, by the end of the 19th century in Britain, it was common for firms to have access to
long-term, as well as short-term, credit, and the real bills doctrine was out of date. It was
replaced on the one hand by the use of interest rates as a policy tool to control the money supply
and the issue of short-term credit and, on the other hand, by a legal framework that treated only
financial contracts that were closely tied to the real economy as valid contracts.

14
III Hedge funds and the theory of speculation

A hedge fund is an investment company that is not required to register with the SEC under the
terms of the Investment Company Act of 1940. In general hedge funds are exempt from both the
Securities and Exchange Act of 1933 and the Investment Company Act due to the “private
offering exemption.” In the decades following the passage of these Acts, this exemption was
interpreted strictly: the hedge fund had to disseminate information comparable to SEC
registration information to all offerees and the offerees had to be sophisticated enough to
understand the information.40

Aggressive lobbying led Congress to amend the SEA in 1980 to create an exemption for
offerings to “accredited investors.” These were defined by the SEC to be individuals with a net
worth of more than $1 million and many institutional investors. Furthermore as long as the
offering was limited to accredited investors, the strict information requirements established by
the Securities and Exchange Act were dropped. This broadening of the “private placement
exemption” allowed the private placements to grow from $18 billion in 1981 to more than $1
trillion in 2006.41

In 1996 Congress again amended the SEA to preempt state regulation of hedge funds and just
about any security subject to the jurisdiction of the SEC.42 Hedge fund advisors are also exempt
from the Investment Advisors Act of 1940 because they are held to have only one client, the
hedge fund itself.43 Because hedge funds are exempt from the Securities and Exchange Act, the
Investment Company Act, the Investment Advisors Act and almost all other regulation, they can
charge fees as a percentage of profits, and do not face constraints on short-selling or leverage.

In 2003 the SEC reported on the beneficial role of hedge funds in financial markets, finding three
principal contributions: (i) the speculative trading positions of hedge funds, because they are
based on extensive research, tend to move prices towards their fundamental values, (ii) by
participating in derivative markets hedge funds take on financial risk, thereby providing liquidity
to these markets and contributing to lower financing costs, and (iii) by using hedges such as
derivatives and techniques such as short selling, hedge funds protect themselves against market
risk and thus are able to offer investors a conservative investment choice that preserves principal
and is not highly correlated with the returns of equity and fixed income markets.44

Of course, in retrospect the last point is amusing. Any industry where it is common to charge 1 –
2% of assets under management, before calculating the profit based fee is unlikely to be able to
afford investing the funds under management in manner that preserves principal. Granted a few
funds (especially the earliest vintage of hedge funds) might actually have innovative enough
strategies to reliably protect principal, earn an acceptable return and pay themselves 2% per

40
Roberta Karmel, 2008, “Regulation by Exemption: The Changing Definition of an Accredited Investor,”
Brooklyn Law School Legal Studies Research Papers #102, p. 7.
41
Ibid., p. 10 – 11.
42
National Securities Markets Improvement Act
43
While the SEC promulgated a new rule redefining the term client in 2004, this rule was struck down by a circuit
court. Ibid. p. 21.
44
Implications of the Growth of Hedge Funds, SEC staff report, 2003,
http://www.sec.gov/news/studies/hedgefunds0903.pdf

15
annum, but there is no theory of investment that indicates that the industry as a whole could
succeed in levitating returns for any significant period of time. We know now that 2008 was the
year that hedge fund returns fell back down to earth – and some might say through the earth.

Hedge Funds and Liquidity

To understand why investment strategies that appear to be based on sound analysis can result in
disastrous losses, let’s consider a classic arbitrage trade. At times a Treasury bond with 10 years
to run that has just been issued may be priced with a yield as much as one quarter of a per cent
less than a Treasury bond with 10 years to run that was issued two decades ago. Because there is
no logical explanation for this difference (aside from the fact that it is too small for anyone else
to bother with), an arbitrageur might predict that it will disappear over time – and that a
profitable trade will be purchasing the high yield 10 year bond, while short selling the low-yield
10 year bond (i.e. borrowing it and selling it, so that you must replace the borrowed bond by
purchasing it in the future). Unfortunately this trade can only earn you one quarter of a percent
on your money, which, if your capital is small, may not be sufficient to cover the time and effort
of finding and putting on the trade.45

In order to earn more from the trade the hedge fund needs to borrow money to invest in the trade.
The problem with leveraging small returns is that in order to generate returns that are worthwhile
the leverage ratio needs to be extremely high: in order to generate a 7.5% return with a strategy
that pays a quarter of a percent the hedge fund must borrow 30 times as much money as it invests
itself. This high degree of leverage has an important drawback: if the assets backing the
borrowed money fall by more than 3% in value (in this example the price of the high yield bonds
would have to fall and/or that of the low yield would have to rise), the hedge fund is going to
have to find additional cash to back the trade. In short a highly leveraged arbitrage trader needs
to be able to predict not only which spreads will converge at some time in the future, but also
that their path to convergence will not deviate too far from current spreads. If spreads do deviate
significantly from the prediction, the only thing that can save a highly leveraged trade is access
to a large pool of capital.

Thus, an arbitrage strategy can be followed safely only if the arbitrageur has access to enough
capital to hold the position even if it moves in the wrong direction. The reason that quarter of a
per cent arbitrage opportunities are not rare is that the return is too low to attract unleveraged
arbitrageurs. Leveraged arbitrage strategies are much more risky, because if the position moves
in the wrong direction and the arbitrageur does not have the capital to meet a margin call, the
broker will go ahead, liquidate the position and realize the losses.

Long Term Capital Management is an example of a hedge fund that managed to lose money
arbitraging 10 year Treasury bond yields. While leverage is the most fundamental problem with
hedge fund arbitrage strategies, another consequence of turning the tiny yields on arbitrage trades
into substantial returns using leverage is that the arbitrageur has to take large positions in the
markets. Meanwhile, the fact that there is an arbitrage opportunity implies that trading is

45
In theory the proceeds from the short sale would cover the costs of the purchase. However, in practice an investor
must post margin with the broker to cover potential losses on the short sale, so in practice profits are indeed
dependent on the investor’s capital.

16
somewhat thin on at least one of the markets. In other words, leveraged arbitrageurs build up big
positions in assets with not-so-liquid markets. One side effect of this process is that, if a
leveraged arbitrageur is forced to unwind a position quickly, the arbitrageur is all but guaranteed
to affect prices. Not only will the arbitrageur affect prices, but the price movement caused by the
unwinding of a position will cause the spread that was predicted to narrow to gap out wider.
That is, when the leveraged arbitrageur’s model is correct, the unwind of the arbitrage position
will cause prices to move away from fundamentals.

As long as every market has only one leveraged arbitrageur, there isn’t much reason to expect
arbitrage to cause serious price dislocations, because the likelihood that spreads will move in a
way that will force an unwind of the arbitrage position is low. In practice, however, arbitrage
strategies spread with financiers from one firm to another. For this reason, it is common to have
several hedge funds pursuing the same leveraged arbitrage strategy in the same markets. When
there are multiple leveraged arbitrageurs trading in the same markets, things can get very
complicated.46

In Demon of Our Own Design Richard Bookstaber proposes that the fundamental cause of the
collapse of Long Term Capital Management (LTCM) was Citigroup’s decision to dissolve
Salomon’s in-house arbitrage group. Salomon, LTCM and a few smaller hedge funds were
frequently arbitraging the same markets. Thus, the dissolution of Salomon’s trades moved many
of LTCM’s spread trades in the wrong direction at the same time. When this effect was
compounded by Russia’s default, LTCM faced margin calls that it could only meet by selling out
of its positions. Unfortunately selling just pushed prices in the wrong direction and led to new
margin calls. During this episode, the spread between low yield and high yield 10 year Treasury
bonds approached half of one percent.

In short, the positions LTCM had taken were so large relative to the markets that once it ran out
of cash to meet margin calls, nothing could save it. In the end, LTCM’s investment bank brokers
were so worried about the losses they would suffer if LTCM continued to unwind its trades that
they jointly bailed LTCM out – LTCM got the massive capital injection it needed to hold on to
its trades, but only after ceding supervisory control of the fund to the investment banks.

The economic case for speculation

In light of the LTCM example the SEC’s claim that the speculative trades used by hedge funds
move prices towards their fundamental values and increase liquidity in markets by transferring
risk seems simplistic. Leveraged hedge funds take such big positions in markets that there
appear to be situations where hedge funds both distort prices and reduce liquidity in those
markets.

Why would the SEC make these claims more than five years after the LTCM collapse? Perhaps
because moving prices towards fundamentals and providing liquidity by taking on financial risk

46
In “The Basis Monster that Ate Wall Street” the DE Shaw Group explain how the positioning of levered players
can affect market prices and, in particular, relate this phenomenon to the 2008 crisis. See
http://www.purearb.com/purearb/wp-content/uploads/2009/03/desco_market_insights_vol_1_no_1_20090313.pdf.

17
are the principal arguments used to defend the economic value of speculation. Possibly the SEC
believed that, despite practical evidence to the contrary, there was support in economic theory for
these views. Unfortunately the theoretic case in support of speculation is not strong.

The argument that speculation is valuable, because it moves prices closer to fundamentals does
not appear to be founded on economic analysis. On the one hand, as an empirical matter it is far
from clear how one would go about establishing whether or not speculation moves prices closer
to fundamentals and, on the other hand, even if we assume that speculation moves prices in the
right direction, there is little reason to believe that these price movements have economic
benefits.

First of all, in the vast majority of real world cases one cannot know whether any given price
movement or sequence of price movements is towards fundamental value or away from it. The
fundamental value of an asset is an ideal that can be modeled and approximated, but almost
never pinpointed with precision. While it is entirely possible that many speculative trades move
prices towards fundamental value, it is also possible that prices move in the other direction
particularly if the speculator’s model is wrong. One can’t even be sure that speculators who
move prices away from fundamental value will lose money – even this proposition depends on
assumptions about the path of price movements that are very difficult to verify.47 In short, the
general claim that speculators move prices toward their fundamental values is a modeling
assumption that cannot be established empirically, because the fundamental values themselves
are unknown.48

Secondly, even if speculation brings prices closer to fundamental values, economic analysis does
not support the view that such price movements have economic benefits. The reason for this is
simple: the standard models that economists use to discuss social welfare are built on the
assumption that prices reflect fundamentals perfectly. In order to consider the possibility that a
change in price brings the price closer to the underlying fundamental price, you have to relax this
assumption. Once you remove the assumption that prices reflect fundamentals, you are in an
environment where an optimal solution is impossible and you are forced to rank sub-optimal
solutions. Unfortunately in a model with two (or more) types of people, most close-to-optimal
price changes will benefit one group at the expense of another – and unless one chooses to focus
on the welfare of a favored group, it is very difficult to rank equilibria. This challenge is
presumably one of the reasons that Grossman and Stiglitz in their seminal article on the role of
profitable arbitrage in price formation promised a welfare analysis that was never forthcoming.49

In the real world, speculation moves prices from one imperfect price to another, arguably less-
imperfect, price. However, whether or not this change in prices is welfare improving for society
as a whole will depend on a variety of factors – one of these is the degree to which speculators
are able to capture for themselves any social gains that accrue to the improvement in prices. A
simple case in which this would be socially optimal is if we assume that everyone’s welfare

47
The fact that its not too hard to make money trading volatility is evidence of this.
48
This general statement is not disproven by the few true arbitrage trades that do take place – such as almost
identical bonds that trade at different prices.
49
Sanford Grossman and Joseph Stiglitz, 1980, “On the Impossibility of Informationally Efficient Markets,”
American Economic Review, 70(3), pp. 393 – 408.

18
increases linearly in dollars so that giving a rich person a dollar has the same effect on social
welfare as giving a poor person a dollar: this is simple to analyze because the distribution of
dollars doesn’t matter, just the number of dollars that the economy generates. Of course, some
economists will argue that this easy-to-analyze framework violates one of the most fundamental
axioms of economics, that for every individual each additional dollar is just a little less valuable
than the last one. Hopefully, you’re now beginning to understand why economists often avoid
discussing welfare when they can’t assume perfectly informative prices.

Given the difficulties intrinsic to analyzing a process of price formation and the need to rank sub-
optimal solutions, it is not surprising that the academic literature on price formation reaches no
consensus whatsoever about welfare effects. Some examples: Spiegel and Subrahmanyam
develop a model where an increase in the number of speculative arbitrageurs may reduce market
liquidity and decrease the welfare of those who need to hedge economic risk.50 By contrast
Bernhardt et al. find circumstances where it is possible for insider trading to reveal enough
information via prices to uninformed investors to make them better off and improve the
aggregate welfare of all agents.51 In an environment where the profits of speculators with an
information advantage come at the expense of other traders, Dow and Gorton find that when
trading by such speculators is profitable, the aggregate welfare of all agents is lower.52 Welfare
analysis in an environment with inaccurate prices is such a complex problem that Dow and Rahi
find that imposing a tax on speculators may make not just society, but the speculators
themselves, better off.53

Let me make this point more simply: Adam Smith’s invisible hand assumes that prices
accurately reflect costs and benefits. Once we start to focus, not the on the approximate accuracy
of prices, but on their inaccuracy, there is no longer any reason to believe that self-interested
behavior promotes the welfare of society as a whole.

Thus, when studying price formation, economists find themselves working with models that
often give counter-intuitive results. And it remains a bit of a mystery why the staff at the SEC
simply assumed that moving prices closer to their fundamentals has some intrinsic social value.
This would only be the case if there were some empirical evidence that the investing public
benefits from the price movement. In circumstances where the value gained from the price
movement accrues to the hedge funds themselves or where the price movement facilitates a
transfer of value from the public to the hedge funds, moving prices closer to their fundamentals
may not be in the interests of the investing public.

To summarize, the appropriate responses to anyone who claims that speculators act to move
prices closer to their fundamental values are: How do you know this to be true? And even if it is
true, so what? Even if the actions of speculators result in more accurate prices, this does not
constitute an argument against restricting the activities of speculators or regulating them.
50
Matthew Spiegel and Avanidhar Subrahmanyam, 1992, “Informed Speculation and Hedging in a Noncompetitive
Securities Market,” Review of Financial Studies, 5(2), pp. 307 – 329.
51
Dan Bernhardt, Burton Hollifield and Eric Hughson, 1995, “Investment and Insider Trading,” Review of Financial
Studies, 8(2), pp. 501 – 543.
52
James Dow and Gary Gorton, 1993, “Profitable Informed Trading in a Simple General Equilibrium Model of
Asset Pricing,” Rodney White Center for Financial Research Working Paper, 5-93.
53
James Dow and Rohit Rahi, “Should Speculators be Taxed?” 2000, Journal of Business, 73(1), pp. 83 – 107.

19
The more substantial argument in support of speculation is that speculators provide a service to
markets by taking on risk that other economic actors would prefer not to bear. This view of
speculators dates back at least to Keynes and Hicks.54 Here, I think it is important to distinguish
between speculators and speculative trades. When speculators protect others in the economy
from potential losses, they are unarguably providing an important economic service. For this
reason, since the 19th century the law has distinguished between transactions that indemnify one
party against losses and transactions where both parties are speculating.55 In short, indemnity
contracts are, by definition, not speculative (or wagering) contracts and cannot be voided by
gambling laws.

The argument that speculators play an important role in bearing economic risk is only valid in
reference to indemnity transactions. By contrast, if the transaction is speculative – or if two
speculators are trading with each other – neither party enters the trade for the purpose of
protecting against existing economic risk, and it is hard to argue that the trade provides a service
to the real economy.

When proponents of financial deregulation argue that speculative financial transactions should
not be outlawed or otherwise circumscribed because these transactions play an important role in
risk transfer, they are creating confusion where there does not need to be any. As a simple
matter of definition a financial transaction that transfers an existing economic risk is not a
speculative transaction. The apparent reason for confusing indemnity transactions with
speculative transactions is to create a smokescreen behind which speculative transactions can
hide.

In short, regulations which are designed to limit over-the-counter speculative transactions, such
as the Commodities Exchange Act, include exceptions that allow for over-the-counter
transactions that have as their purpose the transfer of underlying economic risk.56 There is no
controversy here. Everyone can agree that any law that limits speculative transactions needs to
be carefully written to permit financial contracts that transfer genuine economic risk exposures.

To sum up, the arguments in favor of speculation are extremely misleading. While it is possible
that speculation moves prices towards their fundamental values, there is no reason to believe that
the investing public benefits when such movements take place. Furthermore, the view that
speculators play an important role in bearing economic risk is irrelevant, precisely because laws
that limit speculation have exceptions that allow for genuine transfers of risk. In addition, as
demonstrated by the LTCM collapse, in the real world speculative arbitrage often requires
leverage, and when something goes wrong with the leveraged trade, forced selling by speculators
can disrupt markets, driving prices away from fundamental values and draining liquidity from
markets.

54
Jack Hirshleifer, 1977, “The theory of speculation under alternative regimes of markets,” Journal of Finance,
32(4), p. 975.
55
Lynn Stout, “Why the law hates speculators,” Duke Law Journal, 48(701), pp. 718 – 9.
56
See, for example, the forward contract exclusion to the Commodity Exchange Act.

20
An analysis of the costs and benefits of unenforceable speculative contracts

In chapter one, we found that in the Anglo-American legal tradition speculative financial
transactions are void under gambling laws. Thus one can enter into a speculative contract, but
the judicial system will not enforce the terms of the contract. This may be the best way to
promote efficient speculation.

Consider the properties of a contract between two speculators: First of all, since both parties are
speculators trying to take advantage of (opposite) expectations of price movements, the contract
is not part of the economy’s production process. Secondly, since the contract is not productive,
it is zero-sum, whatever one party loses the other gains. Finally, because the contract does not
involve production and is zero sum (and as argued above there is no social benefit to price
movements), it lacks externalities – the only parties with an interest in the outcome of the
contract are the two parties involved.

The particular character of speculative contracts – that they are of interest only to the two parties
involved and neither contribute to, nor detract from, society – means that social welfare is best
served by not enforcing these contracts. To understand this, one need only consider the costs of
enforcing contracts.

If speculative contracts are legally enforceable, any time spent by a judge or other member of the
judicial system on issues related to a speculative contract is a net loss to society, for the simple
reason that there is no social purpose that can be served by enforcing the contract. Furthermore,
when speculative financial contracts are enforceable, it becomes necessary to determine who is
capable of understanding the risks involved in the contract – and thus who is qualified to
speculate.57 Once more we find that the time of regulators and judges will be spent making
determinations that can generate no social value. In short, the problem with making speculative
contracts enforceable is that the enforcement of such contracts necessarily results in a net loss to
society.

The alternative is to allow speculators to enter into contracts that will not be enforced by the
legal system. When contracts are unenforceable, the “appropriateness” of a counterparty is
determined after the fact by the counterparty’s decision to pay (or not pay) the debt. This state of
affairs guarantees careful assessment of counterparties – including capacity to pay,
understanding of risks and obligations and willingness to pay. Thus the problem of determining
who is qualified to speculate is now solved, because the speculators will bear the costs of
screening their counterparties carefully. Effectively we can expect that the Coase theorem will
come into play here: When the speculator’s costs of finding a reliable counterparty are covered
by the expected gains from the trade, the trade will take place, and when the costs are not
covered, the trade will not take place.
57
The same 1992 law that allowed the CFTC to exempt contracts from the Commodity Exchange Act’s jurisdiction,
also established a rule that all exempted transactions be solely between “appropriate persons.” (The term now in use
is “eligible contract participants.”) Thus, the 1992 act changed the focus of the law from the nature of the
transaction to the nature of the participants. Instead of the self-enforcing traditional environment, legal changes
since the 1990s have forced the courts to determine whether contract participants had the capacity to understand the
risks they were undertaking – when it is highly likely that the judges and the jurors themselves do not have a strong
understanding of the financial contracts in question.

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If speculative contracts are made unenforceable, they will not disappear, but they will become
much more rare. The reason for this is simple: Currently the costs of enforcing these contracts
are born by society, even though society does not benefit from them. When those who may
benefit from the contract are forced to bear the costs of enforcing the contract, they are sure to
find that only a limited set of contracts has expected returns sufficient to cover the costs. The
fact that unenforceable speculative contracts traded regularly in the 19th century provides
empirical evidence that speculative trades are unlikely to disappear.

In short, our 19th century forebears arrived at an economically efficient solution to the problem
of speculative contracts: void them. Because society cannot gain from them, it is foolish to
waste the resources of the judiciary or regulators on them. On the other hand, society does not
lose from them either, so there is no need to render them illegal – the solution is to render them
null under the law.

This approach leaves open the possibility that someone can demonstrate the economic value of a
specific category of speculative contracts. In this case the contracts in question should be made
enforceable under the law – which is effectively what happened over the course of the 19th
century with exchange traded derivatives contracts. On futures exchanges, for example, a very
liquid market in speculative transactions helps support the contracts that actually serve to transfer
risk. Note that this is only true when speculators are monitored to ensure that they do not take
positions large enough to manipulate prices on the underlying market. Thus, exchanges are an
example where the benefits of speculation depend crucially on regulation.

Hedge funds and the economic benefits of voiding speculative transactions

The LTCM experience indicates that the benefits of hedge funds may also depend crucially on
the ability of regulators to monitor them. Hedge funds can be important players providing
liquidity to certain markets (i.e. as speculators taking on risk that others don’t want) and those
that focus on arbitrage strategies can be described as leveraged liquidity providers. They are in
some ways like banks: their ratio of debt to equity is high, they take on risk that others don’t
want to bear, and because their debt is callable, they are unstable institutions. There are however
important differences: a hedge fund’s capital base can be withdrawn in a matter months, and
because they are unregulated, hedge funds face no capital requirements at all. Furthermore,
hedge funds do not have access to a lender of last resort.

Thus when considering the costs and benefits of hedge funds, one must ask: What services do
hedge funds provide that banks do not? And why do banks not provide these services – in
particular do the capital constraints that are imposed on banks make these services uneconomic?
For example, because banks aim to maintain an asset to capital ratio near 5%, banks will not
follow an arbitrage strategy that is only profitable if leveraged 30 times. When low
capitalization is the only reason that hedge funds can provide liquidity services to the market,
regulators need to closely consider the possibility that the instability associated with high
leverage levels may offset any gains from increased liquidity in the market.

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There are a variety of ways to control the instability associated with hedge funds. The amount of
leverage available through their brokers may be limited. Or they may be subject to capital
requirements. Or the sizes of the positions they take relative to the markets in which they trade
may be limited to ensure that the price effect of a hedge fund liquidation is never large.

Observe also that by making speculative trades unenforceable, leveraged hedge funds will be
forced to bear risk for the real economy (since no bank will lend against unenforceable
contracts). Thus a policy of voiding speculative transactions will generate large economic
benefits by encouraging speculators to support the real economy rather than to simply trade
amongst themselves. On the other hand, unleveraged hedge funds can speculate as creatively as
they want – they just have to make sure their counterparties are willing and able to pay up.

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IV Summary of the benefits of a return to the Anglo-American legal tradition

From the earliest days of financial development, norms were established that constrained
financial contracts to meet the needs of the real economy, because from the earliest days it was
necessary to prevent merchants from issuing too many paper debts. By the 18th century the
principal constraint on the paper monetary system was known as the real bills doctrine.

In the 19th century Britain outgrew this system of financial control, developing long term credit
markets together with a monetary system based on checking accounts and bank allocated credit.
Laws and judicial decisions constrained British credit markets by treating only those contracts
that were closely tied to the real economy as valid. At the same time money and short-term
credit markets were restrained by the Bank of England’s use of Bank Rate.

These financial tools remained in force in both Britain and the United States throughout most of
the 20th century. By the 1990s, however, with financial crises a distant memory, the distinction
between speculation and investment that underlay 19th century financial law was beginning to
erode. Gambling seemed too low a term to apply to high finance and there was a sense that the
law was out of date. In this environment, contracts that in the past were treated as wagers
became enforceable. When regulators questioned the changing legal infrastructure, new laws
were passed to definitively liberate speculative contracts from the constraints of the past.

The question, of course, is whether this rewriting of the legal infrastructure supporting our
financial system was a good idea. When a transaction is speculative for both parties, it does not
affect the real economy and thus is a matter of indifference to society as a whole. For this
reason, the resources of the judicial system are wasted when they are spent adjudicating
speculative transactions. On the other hand, when speculative transactions are void under the
law, participants will have to vet their counterparties carefully to ensure that they understand the
transaction and are willing to make payment. By forcing the participants in the speculative
transaction to bear the costs of monitoring counterparties, the traditional legal structure promotes
efficient speculation.

Our financial system and the real economy that depends on it would be well served by a return to
the legal structure that supported 19th and 20th century growth by making only those contracts
that supported real economic activity legally enforceable. Purely speculative transactions would
be legal, but unenforceable and thus ineligible as collateral for a loan. Hedge funds and other
financial market participants would only be able to leverage transactions that were closely tied to
the real economy.

The principle that financial markets exist to support the real economy is fundamental. An
important function of the legal system is to promote this principle by invalidating financial
contracts that are purely speculative. Our forebears understood this. We unfortunately have had
to relearn ancient lessons the hard way.

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