i. When, as political economists, we encounter credit derivatives and other synthetic financial objects, we must not overlook that their progressive differentiation from generic finance signals an important phase transition in our dynamical system of economic institutions, with deep historical, materialist significance.
Brief consideration of the ontology of a single name credit default swap (CDS) already illustrates this truth.
A CDS is a bilateral exchange between two parties –one of whom is called the protection buyer, the other is called the protection seller. The terms of exchange of the CDS make reference to a certain notional value, which is the payment obligation of a reference entity. The protection buyer pays the protection seller a cash premium on a quarterly, annual, daily, or any other agreed-to periodic basis. In return, the seller agrees to make protection payment to the buyer upon occurrence of a credit event in the reference entity [figure 1]. The object of this exchange is therefore called a credit default swap, because the parties to the exchange are swapping the risk of a default or some like credit event on a credit/debt obligation.
Someone or something somewhere owes someone or something else money. This debt obligation comprises the reference obligation of the reference entity: there has been some preceding generic financial exchange of some generic financial asset (i.e. a mortgage, a bond, or some other debt asset), whose event risk and cash flow the CDS replicates. However, while the CDS makes reference to this generic financial asset, its value, and the single name of the obligor party to the generic financial exchange, the parties to the CDS may be (and usually are) otherwise independent of and unrelated to the generic financial exchange. For this reason the exchange is ‘synthetic’. We call the exchange of credit derivatives –in this case the exchange of a CDS– a ‘synthetic financial exchange’ because the exchange involves a synthetic swapping of the risk and cash flow of a reference entity, derived from a generic financial exchange, but to which neither party to the synthetic exchange need be party to begin with.
ii. We have provided an elementary description of a single name CDS commonly found in any literature on credit derivatives, so let us consider its elementary material significance.
We have observed that this kind of exchange is called ‘synthetic’ insofar as neither party to the exchange is required to have original exposure in the generic financial exchange, whose asset comprises the reference obligation from which the synthetic financial exchange of the CDS is derived, and on which to begin with the entirety of the CDS transaction is ostensibly predicated. Therefore, when attending to the process of ‘synthetic replication’ of a generic financial asset, we should observe that the CDS is an economic object to be exchanged like any other, but only insofar as it is a process: a credit default swap is both an economic object (viz. an asset, a commoditized object) and a process (viz. a technology) for the synthetic replication of a generic financial asset; it is the constitutive process of the exchange that actualizes the synthetic asset, as such, rather than the exchange constituting an exchange of some preexisting, pre-actualized asset.
However, unlike any other economic object, there is no inherent limit on its capacity to replicate and distribute itself ad infinitum. Comparison with the other two classes of exchange quickly reveals why this is the case:
- In a classical exchange, which is comprised of physical objects, a specific coat requires a certain amount of cloth, whose availability places physical limitation on the number of coats in circulation.
- So too in a generic financial exchange, which is comprised of generic financial assets, the financial asset of, for instance a mortgage, correlates to the physical object of the house; and the loan-to-value ratio of any mortgage is necessarily bound by its correlation to the house as a physical structure.
- In a synthetic financial exchange, by contrast it is enough that: (a) only one coat, or one house, or one mortgage exists; so that (b) the economic properties of risk and cash flow otherwise linked to that asset (i.e. the one coat, one house, or one mortgage) can be synthetically replicated ex nihilo and ad infinitum; in order to (c) create a new asset in itself –which is the synthetic financial asset.
iii. When we say, then, that the parties to the CDS have ‘swapped’ the risk of default on the obligation of a reference entity, we are observing that they have synthetically exchanged a risk and cash flow otherwise adhering to a generic financial asset, i.e. as two economic properties otherwise attached to the generic asset. But let us keep in mind that prior to the exchange of the CDS, neither party to this synthetic exchange need be originally exposed to any risk or cash flow connected to the referent. Ownership-of, or exposure-to, the referent is not a requirement for transacting a synthetic financial exchange –which means that neither the protection seller nor protection buyer need be the obligor, or creditor, in the preexisting generic financial exchange. But to the extent that the protection buyer and seller transact a CDS, they have created a new asset, and this asset does have the very real material economic properties of risk and cash flow.
In this respect, we will observe that the act of synthetic exchange effectively creates –synthetically, yes, but no less in reality– a risk and cash flow which did not exist before. There is no transfer of private property, no concrete production by labor of any classical economic object, and whose intrinsic value is supposedly congealed therein, nor any new generic financial asset or reference obligation. And yet, through the process of synthetic exchange, because there has occurred a new and ex nihilo proliferation of the economic properties of risk and cash flow, we cannot meaningfully deny that a synthetic exchange is any less an exchange, or lacking in profound material consequences.
In fact, the peculiar materiality of the synthetic financial asset now raises the important question of whether it is the either the case that we need to liberalize our prior understanding of materiality, or even that the actualization of synthetic finance already radicalizes the very concept of materiality itself? This is an issue for further examination by speculative materialism.