Dinosaur Derivatives and Other Trades. Josse Jeremy

fact, he pondered the question of whether there were any callers at all on the other side of those phones.)

      Unsurprisingly, the option eventually went to one such telephone bidder. Since the name was never revealed, the audience had no way to tell whether it was the auction house itself that had won. In any event, the moment the hammer fell, calm descended. What had been a rising frenzy of speculation was brought to an abrupt halt by the auctioneer.

      But the bidding was far from over. Soon other assets were presented before the eager audience. There were many curious ones, including even a letter of credit presentable on the coming (or second coming – which ever turns out to be first) of the Messiah.

      As the auction continued at a furious pace, Karl found himself beginning to dissociate. Later on, when he confided in me, he told me how he felt all the trade occurring in that room amounted to an intensely refined essence of pure contractual dystopian risk. Sitting there, surrounded by throngs of bidders chasing after obscure bearer notes, negotiable instruments, and oblique rights of all kinds, he began to experience a spinning, unbalanced sensation. (I could relate to this: it's a feeling I've felt in many a business meeting.)

      Equally unsettling was the way more people flowed into the auction chamber like flies attracted to the glowing light of the market. There was a sense that something important must be occurring here. Many bodies started to fill the back of the chamber where no seating remained. Some of these new entrants began to buy, but it was obvious to Karl that many had simply come to gawk at this grand enterprise. They looked on in astonishment, but there was also envy in their expressions – as if to say, “If only I could play in this high-stakes game!” The air in the room became stifling. As Karl later explained to me, he began to feel physically oppressed. The mood in the auction rose to a fever pitch. It now seemed like a creeping psycho-pathology had gripped the room. In that chamber the market had taken on its own energy. Amid the clamor of bids, it was as if the collective were giving birth to a deranged new child.

      Ultimately, Karl himself was overcome. “What nonsense! What a mania!” he finally called out. He stood up bewildered, but then collapsed on the floor. After that everything went black.

      That's the story, as Karl recounted it to me. The reader must make his own judgment as to whether the story is true, one of Karl's dreams, or a plain fabrication. Perhaps some readers might feel that such fevered bidding for putative contracts is quite incredible, or highly exaggerated. But I believe it's more likely that all of us have, at some time, witnessed similar occasions when people seemed overwhelmed by financial exuberance or folly. Because, whether the bidding is for Megalodons or for anything else, the dynamics of such an auction house are strikingly familiar to anyone who deals in finance for any length of time.

      The fact is, it requires just a handful of features to create a market for an asset. And none of these features has anything to do with the asset itself having what we might call “real” or “intrinsic” value. So let's start by asking how on earth could the market for Megalodon call options ever have begun?

      First and foremost, there's the great machine of salesmanship. The dinosaur option itself is born in the office of some real-life brokers. Call them wacky, creative, or unscrupulous, their method is a traditional one. First they conceive of the option structure, then document it, and finally generate some bids. They do this by taking what auctioneers call “bidding off the wall.” That is, brokers just start marking up prices or trading between themselves – colluding, you might say. As they begin playing with the supply of the asset, they are not really making money, just getting some notional liquidity going. (For established public securities this can often be illegal – but only for established asset classes.)

      Soon after, the brokers start setting a clearing price for the option, with bid and ask spreads. With this tentative beginning, a market in the asset is thus ceded. There is now potential for the option value to go up and down.

      Funnily enough, something like this really does happen even with the most legitimate and mainstream of Initial Public Offerings (IPOs). The investment bank that leads the offering is typically given what is known as a “greenshoe right” which allows that bank (legally) to “manipulate” the market in the new stock. In summary, on closing an IPO, the underwriter sells more stock than is actually being offered. This creates a technical “short” in the market. If demand for the new stock in the aftermarket turns out to be low, the underwriter fills the short by buying stock from existing stockholders, thus (artificially) creating at least some base secondary market demand. If, on the other hand, purchase orders in the immediate aftermarket are high, the underwriter “exercises his greenshoe.” This allows him to call for more stock from the issuer to fill the demand, hence putting the brakes on an excess rise in the stock price.

      This type of “stabilization” (as it is known in the securities business) is in fact considered by the SEC an important function of investment banks – at least for a limited period after an IPO. It is meant to avoid excessive volatility in the newly-issued stock. So, under SEC regulations, there is nothing “wrong” with it, per se. Still, it is a very telling example of how brokers themselves can affect the value of an asset merely by playing with the notional demand and supply of the stock.

      So – now a base market for the Megalodon asset has been created, and with that we are off to the races. For then the vast network of intermediation begins to operate. Prospective buyers are encouraged to participate by armies of salespeople present in many advanced capitalist economies. The asset becomes increasingly known. At first, it is offered only to exclusive groups. And I mean really exclusive groups – groups that Karl could not even dream of joining. But in time it gets offered to a clientele that, though still exclusive, is drawn from slightly less rarified circles. At this level, Karl might be invited in. Said clients are now gratified – flattered even – to be allowed in to what they see as an exclusive cadre of investors. Eagerly they invest. In time the brokers could step away from the market – although, of course, they never do as they wish always to keep oiling the gears and pouring in the fuel, keeping the engine burning. In time, investors become accustomed to buying and selling at certain established price levels. The asset has “obtained value.”

      The U.S. legal system fully recognizes these types of investor stratifications. Under current SEC and FINRA rules, certain securities can only be sold to “accredited investors,” defined as those having annual incomes of $200,000 or to those whose net worth exceeds one million dollars. Still more exclusive offerings can only be sold to Qualified Institutional Buyers (institutions managing at least $100 million in assets). Now, these rules might seem arbitrary, but do nevertheless have some rationale. By imposing these stratifications, the laws are meant to protect the “non-qualified” from being sold overly risky securities. The rules don't always work. But when (if) they do, they are important mechanisms for protecting those with limited means, from buying assets exactly like dinosaur derivatives. “Non-sophisticated” investors really shouldn't be buying assets whose value is, we might say, highly elusive or heavily driven by speculative demand. But the cautionary intention of the rules comes with a backlash directed by the all-too-human emotions of envy and desire. If you do make it into one of these specialized investor buckets – well, what a privilege! All the more enticing is the prospect of playing in a game restricted to an elite.

      So our asset has by now attained some perceived value in the market. But then a second, powerful financial force comes into play. It's called “liquidity,” which is the notion that someone else will always buy or accept the option for value at a later stage. In fact it is recognized by financial commentators that investors often buy an asset only because they are confident someone else might buy it (hopefully, at a higher price) in the near future. The immense herd of brokers and salespeople have now upped their game still further: they are industrializing the exchangeability of the Megalodon option. And this in turn brings us to another notion – the “greater fool theory.” Namely, that in any chain of transactions when an asset value is rising there is always (usually) a “greater fool” who will bid even higher. Of course, this can never be an endless chain. Eventually some buyer gets caught out acquiring the asset at the end of the chain before the price falls.

      It's a sequence eloquently described by Charles Kindleberger and Robert Aliber