Twelve years ago, in ‘Inventing Money’ I explained the principles of option pricing to a general audience. Although the maths looked complicated, the financial market that Fischer Black, Robert Merton and Myron Scholes modeled in the early 1970s was really quite simple. You bought and sold derivatives, such as options or forward contracts, and traded between the underlying assets, and a liquid cash account.

The cost of replicating the derivative was equal to its price, because otherwise traders would arbitrage the discrepancy away. With that Nobel prize-winning concept in place, bankers and regulators thought you could safely trade and hedge as many derivatives as you wanted – and that’s exactly what people did from the 1980s onwards, creating a multi-trillion dollar market.

The ‘law of one price’, enforced by replication and arbitrage , resembled a financial law of nature. It made derivative pricing particularly attractive to people from a physics background. One of the greatest achievements of twentieth century physics was Quantum Electrodynamics which described the behavior of particles like electrons and photons. QED was ‘perturbative’ in the sense that complex interactions between particles were less important than simple ones.

In the 1970s model of financial markets, complex interactions between traders involving liquidity or counterparty default were also minor corrections to derivative pricing that in practice were ignored. Once you defined the instrument – a barrier option or an interest rate swap – its price was the same for everybody in the market.

Today, the kind of market that Black, Scholes and Merton modeled in the 1970s seems quaint in the wake of the financial crisis. At a conference in Barcelona’s Hotel Arts in April, I watched quants grappling with a new landscape of counterparty risk, collateral and clearing houses, that has turned the old world upside down.

Consider the old framework of derivative pricing in which counterparties enter into derivatives contracts with one another, while buying and selling the underlying asset to hedge themselves, dipping in and out of cash accounts. The starting point today is counterparty risk, collateral and cash.

Before you take on counterparty exposure, you need to think about these counterparties’ credit spreads. How volatile are they? What’s the ‘jump-to-default risk’? That drives a crucial parameter, the credit valuation adjustment. Of course, you might default before they do, and the possibility that you might not pay out on a derivative becomes valuable as your own credit spreads widen. Enter the debit valuation adjustment. These two quantities, CVAs and DVAs, make derivative trading books at major banks lurch around like aircraft in a thunderstorm.

Then there’s the cash and collateral aspects of derivatives. For banks everywhere nowadays, cash is precious: if holding a derivative requires a cash account for its hedging strategy, that means borrowing money somewhere to fund that. Can you pledge the derivative as collateral? Can you lock in a deterioration in your own creditworthiness by using the cash to buy back bonds? That leads to another correction, the funding credit adjustment, that also needs to be added in.

One answer to the problem was supposed to be the posting of collateral to cover swings in the mark-to-market value of a derivative. That was fine when there was an unlimited supply of highly-rated bonds that everyone assumed were interchangeable – Treasury bills, Italian bonds, collateralized debt obligations. This is no longer the case as safe assets become increasingly contested, and the safest thing of all – cash – is like blood.

Along with CVAs, DVAs and FCAs, the credit support annexes that govern the posting of collateral have now become equally crucial parts of a derivative contract. What kind of collateral can you post, and in what currency? Can you re-pledge or hypothecate it? How do you discount the value of that collateral? And if a counterparty defaults suddenly at a time when markets are highly volatile (which isn’t implausible), even a CSA won’t necessarily protect you.

In today’s world, the derivative that used to be the same for everybody sits on top of these new components, like a decoration on a wedding cake. Pricing has become context dependent, as CVAs and CSAs throw out different numbers depending on what positions a bank already has, and what collateral it owns, and how the market perceives its default risk. A keynote speaker at the Barcelona conference, BTG Pactual’s Tom Hyer, suggested a new paradigm for derivatives was necessary.

I would go back to a physics analogy. In particle physics, the euphoria over the success of QED wore off when the theory was adapted to account for the behavior of unseen particles trapped within atomic nuclei – quarks and gluons. That theory, Quantum Chromodynamics, was ‘non-perturbative’, in other words, the more complex interactions dominated the simpler ones. That made the physics much harder.

Derivatives today are like that. Complex interactions between banks and within portfolios dominate the pricing of derivatives, as opposed to the behavior of the assets the contracts are supposedly ‘derived’ from. Maybe that’s nature’s way of telling us to make the banks, and the market simpler.

My story (with Elisa Martinuzzi) about Italy admitting it paid Morgan Stanley billions to unwind derivatives, and the Telegraph’s superb reporting on the alleged mis-selling of derivatives by banks like Barclays to small British companies, have something in common.

Small British companies and Italy share an environment where both of them are finding it hard to access credit and roll over funding. You’d think the emergency measures by central banks to keep borrowing costs low (by purchasing government bonds or helping banks to do so on their behalf) would make things easier. Unfortunately, the benefits are being counteracted by the impact of derivatives that these borrowers purchased before the crisis, when bond yields were higher.

Put yourself in the shoes of a borrower in the years before 2007, when government bond yields were around four or five percent. In the case of Italy, you could borrow freely for periods of five or ten years – to the tune of trillions of euros. Officials at Italy’s treasury wanted to lower the repayment costs, and investment bankers offered them derivatives – swaps and options – that spread the costs over a much longer period, say 30 years. It turns out that Italy bought 160 billion euros of these things.

Small UK companies were dependent on banks for long-term loans, and the banks pushed them into buying derivatives that fixed their loan rates for 30 years or more. Like Italy, the derivatives often lasted much longer than the underlying loan.

In both instances, it took two unanticipated events happening simultaneously to turn this into a problem. On one hand, the financial crisis reduced access to funding, pushed banks to recognise their counterparty exposure on derivatives, and forced borrowers to tighten their belts with austerity measures. Meanwhile, the emergency measures by central banks caused euro and sterling swap rates (which respectively track German and UK government bond yields) to plunge. That made derivatives where banks received long-term fixed payments incredibly valuable.

Things came to a head in two ways. The UK companies had been required by the banks to enter into mark-to-market collateral agreements on their swaps. As the derivatives moved in their favour, the banks were able to immediately demand collateral, draining the companies of cash. Italy was luckier because it didn’t have to post collateral. Instead, the problem involved options or forward-starting derivatives that were reaching maturity and kicking in, increasing Italy’s borrowing costs at the worst possible time.

In Daniel Kahneman’s book ‘Thinking Fast and Slow’ (which I will be reviewing shortly) there is a section on what he calls ‘hindsight bias’: after some disaster has happened, peoples’ recollections of the probability they ascribed to it are much higher than their actual beliefs at the time. Kahneman is irked by pundits who claim that they ‘knew’ the financial crisis was ‘inevitable’.

Kahneman would rightly say that no-one knew with certainty five years ago that the interest rate derivatives bought by Italy and small UK companies would cause such trouble today. However, a better question to ask might be what probability the markets gave five years ago to the scenario that bond yields and swap rates would fall to today’s levels.

While credit default swap markets ascribed minute probabilities before 2007 to the subprime and Greek defaults that would eventually come to pass, interest rate derivatives markets priced in much higher likelihoods of a low rate world. This was driven by demand – as early as 2003, insurance companies and pension funds were worrying about how low bond yields would affect the cost of their fixed liabilities.

In 2006, I reported that Munich Re bought 12.5 billion euros of receiver swaptions (options on swaps) from Morgan Stanley for this purpose, at the same time that Italy was selling them. A few UK pension funds, such as WH Smith, First Group and HSBC, were also active at this time, contracting to receive long-dated fixed payments on swaps at the same time as small UK companies were being steered onto the other side of such positions.

In the case of Italy’s treasury, there can be no excuse for not understanding the risk of low rates when they were effectively betting with Italian taxpayers’ money. By contrast, small UK companies cannot be labeled as ‘sophisticated’, and may not have understood what they were getting into.

What Italy and the small UK companies do have in common when it comes to derivatives is a problem of secrecy. Having seen the role that derivatives played in Greece’s problems, I’ve been pushing for a while for the Italian treasury to come clean on its derivatives exposures. Fortunately, our story on Friday seems to have had an impact. In the UK, it’s a scandal that Barclays prevented its clients even from talking to the Financial Services Authority about swap contracts.

Perhaps that’s the most important lesson: secrecy breeds muppets.

Most journalism is a hit-and-run affair. We talk to sources, check facts, agree quotes, wrestle with editors and lawyers; the excitement builds up to the point the story appears…and then we drop the whole thing and move on. When I published my story on Goldman Sachs and Greece in July 2003, the almost-universal reaction was: EU member states were flouting the Maastricht Treaty with the help of investment banks – so what? We now know that what I uncovered eight years ago was a sign of the Eurozone’s rottenness. Over the last month, as Greece approached default, I’ve been lucky to have had a chance to revisit my story and uncover some new facts with the help of the BBC and Bloomberg. You can watch my BBC Newsnight film here;

the ten-minute film was directed by Mark Turner and the broadcast date was 20 February. My Bloomberg feature (co-authored with Elisa Martinuzzi) was published on 6 March and can be read here. It was the most-read story on Bloomberg’s website last week.

All the talk about Greece trying to persuade its creditors to swap some once-valuable bonds for new ones worth much less reminds me of another Greek swap that I wrote about in 2003. That deal with Goldman Sachs, designed to conceal part of the country’s ballooning debt-to-GDP ratio in order to conform to the rules for Europe’s single currency, was analysed by EU statistics agency Eurostat in a report published last year.

Although the report’s credibility is undermined by Eurostat’s straight-faced insistence not to have known about the swap until 2010, it does provide some insight into the Greek governance that got the country into its current mess. In particular, there are some telling analogies between the product that Goldman sold Greece and the mortgage products that U.S. financial companies sold to subprime borrowers during the housing bubble that ended in 2007.

The swap was structured in June 2001 and had two components. One was a series of cross-currency swaps by which Greece’s historic foreign currency borrowings in dollars and yen were converted into euro debt for accounting purposes. Normally, these contracts are transacted at the prevailing spot exchange rate, and have zero value. In Greece’s case, these swaps were transacted at a fictitious exchange rate, reducing the size of the debt by €2.4 billion. According to Eurostat’s accounting rules at the time, this was a perfectly legal thing to do.

The second part of the transaction is where it gets more revealing. Because the ‘off-market’ cross-currency swaps had a positive value for Greece, they were in effect a loan from Goldman. To repay the loan, Greece entered into a separate off-market interest rate swap which had a positive value of €2.8 billion for Goldman (this amount included a €400 million charge for unwinding some additional swaps). A payment of fixed coupons from Goldman to Greece was more than counterbalanced by a stream of floating-rate payments going the other way that would last until 2019, paying off Goldman’s loan, along with interest and fees.

There was more to this unusual interest rate swap as Eurostat pointed out. The floating rate was not a plain-vanilla money market rate such as Libor. It was ‘actively managed’ according to the report, and was tweaked several times. ‘This is a feature which does not seem to be commonly observed in normal market practices’, is how Eurostat described it. The swap also included a grace period of two years before Greece would actually have to pay any money to Goldman.

In effect, this grace period resembles the so-called ‘teaser rates’ that were popular among subprime borrowers during the U.S. housing bubble. Teaser rates typically lasted for two or three years and temporarily insulated borrowers from crippling mortgage costs that would kick in once the introductory period expired. To avoid foreclosure, subprime borrowers would refinance these mortgages before that happened, an exit route that was possible so long as house prices were rising.

Consider the similarities in Greece’s relationship with Goldman. Like a subprime borrower, Greece was overly indebted and showed little ability to get to grips with the problem. The Goldman swap was akin to a ‘liar loan’, where Greece could keep its troubles secret. The grace period on the swap made the problem briefly look affordable. The analogue of house price appreciation was the deficit, which the Greek government forecast would disappear in a few years’ time, providing enough income to eventually pay down the swap. To keep the illusion going, Greece went back to Goldman and tweaked the deal, extending the grace period for another couple of years each time round.

As with subprime loans, Greece was not really getting an interest holiday during its grace period. The interest and fees were racking up out of sight and getting added to the loan balance. With subprime, this was known as ‘negative amortization’. The Eurostat report shows what the impact was, when in early 2005, Greece refinanced the hidden loan. This time round, Goldman restructured the swap and sold it to a recently-privatized Greek bank, National Bank of Greece. This meant that the swap had to be marked-to-market, at a value of €5.1 billion.

How costly was that for Greece? In 2001, Greece publicly issued ten-year bonds that paid a coupon of 5.35 percent. If Goldman’s €2.8 billion loan had been compounded at this rate for four years, Greece would have owed €3.4 billion in 2005. To get a loan amount of €5.1 billion is equivalent to Greece paying a staggering 16.3 percent annual interest rate. This additional cost may be connected with the structured product nature of the swap which entailed Greece making bets on market moves in interest rates and inflation indexes that performed badly.

Rather than facing up to its problems in 2005, Greece extended the maturity to 2037 from 2019 in order to keep annual costs down, with a new grace period of two years. The efforts were in vain, and in 2010, Eurostat forced Greece to reinstate the hidden debt on its balance sheet.

Today, Greece is widely expected to default on its $350 billion of outstanding debt. In the U.S., $750 billion of outstanding mortgage debt is underwater, and $200 billion is in default. In both cases it was tempting to rail at the spendthrift and insist on full repayment, a position that has been exposed as being futile. Some countries, like consumers, are unable to resist financial products that play on their weaknesses and worsen their problems.

On page 277 of The Devil’s Derivatives, there is a short account of how the U.K. Financial Services Authority supervised the Royal Bank of Scotland in the spring of 2008. It’s only a small part of the book, but it caused me a disproportionate amount of trouble, including a legal threat from the FSA that caused me to change my U.K. publisher and delayed publication of the book by several months. Last week, compelled by U.K. parliament, the FSA published a 452-page report on RBS.

The passage in my book focuses on an FSA employee called Clive Adamson. He was what my sources called a ‘good old-fashioned bank examiner’, who had been brought over to the FSA from the Bank of England in 2000. By 2007, he was involved in supervising RBS, as part of an FSA division called ‘major retail groups’.

Towards the end of 2007, and early in 2008, as the crisis progressively worsened, Adamson is said to have become frustrated about the poor quality of disclosures that RBS was providing about its capital position. However, Adamson’s ability to act on his concerns was constrained by other forces within the FSA. In the decade since its formation, the FSA had accumulated a hierarchy of risk experts, many of whom worked on the mathematical modelling required for the Basel II regulations. RBS legally exploited Basel rules to the full in order to hold the bare minimum of capital and deliver the maximum return to its shareholders.

Adamson’s critique of RBS, the FSA risk experts said, was tantamount to admitting that the regulator had made a mistake on Basel II, in which it had invested thousands of hours of analysis and negotiation. The tensions between Adamson and the risk experts broke into the open at an FSA internal meeting in the spring of 2008, in which Adamson supposedly described the RBS Basel-mandated disclosures as a “pack of lies” and was reproved for it by a colleague I shall call X. Feeling that the senior management of the FSA was not sufficiently supportive of their position, some FSA staff took it upon themselves to informally contact the U.K. Treasury to discuss how British banks might access capital in an emergency.

The FSA told me that my account was ‘inaccurate’ and not only warned me that naming X would be defamatory, but said that FSA senior management reserved the right to sue me as well. Worse still, the FSA threatened me with criminal prosecution citing provisions in the Financial Services & Markets Act of 2000 intended to protect confidential information passed by banks to regulators. Faced with such a threat, I couldn’t take the risk. I had wanted to make more of Clive Adamson, who I thought was something of a fine fellow, but doing so would have risked either exposing me to legal action or would have exposed my sources.

Eighteen months later, the report itself does provide some indirect corroboration for the passage in my book. There is the context of light-touch, under-resourced regulation of large banks and over-allocation of resources to Basel II. There’s evidence of the poor risk disclosures and defence of the status quo which irked Adamson. We see it in an exchange over RBS’s liquidity that took place in November 2007, where the supervision head of department demanded more information, and a specialist FSA team went back to visit RBS and appears to have been fobbed off.

We also see it in the account of what the FSA calls ‘Pillar 2′ supervision — where banks and regulators engage in dialogue to determine capital levels on top of the ‘Pillar 1′ standard rules.
In late 2007, RBS’s Pillar 2 submission to the FSA was deemed to be of ‘insufficient quality’ by the supervision team, because the bank insisted on estimating capital using a 1-in-40 worst case scenario rather than the 1-in-1000 standard laid down by Basel rules. If RBS had followed the guidelines properly, it would have needed an additional £7 billion in capital, the report says. That calculation didn’t allow for the acquisition of ABN AMRO, which the FSA now admits should never have been allowed to proceed.

So why wasn’t RBS forced to increase its capital by £7 billion in late 2007? Because the FSA would have had to have admit that the Basel rules were wrong. ‘A significant departure’, the report quotes the supervisory team saying, ‘takes some explaining as to why we so massively underestimated the capital impact of the risks facing the group under Basel I’. If I was Adamson, I would have been feeling peeved at this point.

In early 2008 we see the FSA start getting slightly tougher, pushing RBS to focus on a stricter definition of capital – core Tier 1 rather than the arbitrage-friendly Tier 1 – giving the bank a year to increase the ratio to 5.25 percent (for comparison, the European Banking Authority now wants banks to exceed a core Tier 1 ratio of 9 percent).

These capital targets, incredibly weak by modern standards, were too much for RBS in the spring of 2008. In March, the bank admitted falling below the FSA required level, and did so again in April. That month, an internal FSA paper noted RBS’s ‘poor capital planning and forecasting’.

It is the first week of April when things really pick up. According to the report, the FSA’s managing director of retail markets, Clive Briault, left on 7 April, and Adamson was immediately promoted to become acting director of retail groups. Now I don’t want to be unfair on Briault, who took the blame for the Northern Rock fiasco and was forced to quit the FSA as a result. Briault rightly says that the main reason for Northern Rock’s failure was lack of liquidity, something his team was not required to regulate. A similar argument about liquidity is made in the RBS report, and it would be wrong to pin the blame on Briault for the failure of RBS.

That said, his departure and Adamson’s elevation are correlated with a striking change in the FSA’s supervision of RBS. Only 48 hours later, on 9 April, FSA chief executive Hector Sants met Sir Fred Goodwin, and demanded that RBS pursue a rights issue. It is hard to imagine a greater slap in the face for Goodwin, who up to then had thought he was walking on water, unchallenged by regulators or shareholders. After 9 April, he was offering his resignation to the RBS board (they declined to accept it) and the bank was apologising to analysts in conference calls.

The report acknowledges that the £12 billion rights issue and pledges of asset sales by RBS in April 2008 were not enough. Outside the remit of the report are the conversations that took place at the Treasury and Bank of England about RBS during this time. All the report says is that the FSA updated these authorities through the official ‘tripartite’ channels. But were there unofficial discussions between FSA staff and the Treasury as my sources suggested?

Today, Adamson is the head of supervision for the entire FSA, and he is likely to return to his old home as a prudential regulator at the Bank of England when the FSA shuts down next year. Unfortunately, many of the Basel experts whom he jousted with are likely to move over with him.

Hearing David Cameron’s justification for his rejection of last week’s proposed EU treaty changes on the basis that he was defending the City of London as a financial centre, I was reminded of a talk given back in April by Michael Hintze, the head of $11 billion hedge fund CQS and a major Conservative party donor. Ironically in the light of what happened last Friday, the talk was given in Paris, at an event called Global Derivatives. The audience mostly consisted of traders and quants from investment banks and hedge funds – an audience that you might think would be lapping up every word Hintze said.

In his speech Hintze launched a blistering attack on the regulation of derivatives and short-selling. He had armed himself with some statistics from the Bank for International Settlements, and noted that the outstanding amount of credit default swaps had declined significantly since reaching a peak of around $60 trillion in 2008. This was a bad thing, Hintze argued, because it showed how increased regulation was reducing market liquidity.

This left people in the audience scratching their heads. One of the few regulatory initiatives that derivatives bankers agree was unquestionably a good thing was the move in 2005 by the New York Fed and Financial Services Authority to crack down on the shoddy back-office paperwork underlying CDS contracts, and the needless profusion of trades designed to cancel each other out, which helped inflate the BIS notional to $60 trillion. The financial crisis would have been even worse had this not been done, and the efforts post-crisis to ‘tear-up’ or ‘compress’ CDS trades has made the system safer.

Hintze went on to lambast Basel III, restrictions on short-selling of European bank stocks and sovereign CDS and other responses to the crisis. When he finally relinquished the podium, the panel of industry worthies that took his place distanced themselves from the views he expressed. One of them, the academic Dilip Madan, a derivatives expert who has done a lot of consulting work for investment banks, went so far as to say that some derivatives regulation was actually necessary.

Hintze may have had reasons to vent that day. Shortly before the conference, CQS had launched a hedge fund with the help of investment manager Schroders that would take long-short positions in European corporate bonds and CDS within a tight EU regulatory framework called UCITS. Presumably, this fund would not have been able to use CDS to short European banks and sovereigns, trades which from today’s perspective would have been highly profitable. Although he was not personally responsible for managing this fund, perhaps the sight of colleagues jumping through those UCITS hoops had coloured Hintze’s views somewhat.

Of course, Hintze doesn’t think that all regulation is bad, and some of his arguments have been already made elsewhere. That said, Hintze’s stance on regulation seems extreme by City of London standards. However, I suspect that his views carry some weight in Conservative Party circles. This may go some way to explaining why Cameron wrapped himself in the mantle of the City as justification for exercising his veto last week, a move that many people in the City think will actually damage the UK’s regulatory interests in the EU.

On Nov. 3rd, I attended the inaugural BBC Today Business Lecture, given by Bob Diamond, the chief executive of Barclays. The man who told the UK Treasury Select Committee that it was time to stop apologising for the financial crisis had been given an image makeover. Taking an ingratiating tone towards his audience of BBC worthies, MPs and journalists, Diamond used words like ‘trust’, ‘citizenship’ and ‘responsibility’. Oozing contrition and sincerity, he peppered his speech with well-calibrated examples of Barclays helping business clients.

Diamond seemed hurt when I stood up at the end and pointed out that Barclays’ track record of selling over-complex products and exploiting opaque balance-sheet tricks made it hard to believe him. The more I thought about it, aside from the change in tone, there was not a great deal of difference between the unrepentant Diamond addressing the Treasury Committee and the contrite version lecturing the BBC. What did nag at me after the lecture was why he was taking the trouble: in particular, publicly disavowing any threat to move Barclays to the US.

The answer came to me last week, when I visited Capitol Hill in Washington DC to give a presentation of my own on the implementation of the Volcker Rule, which bans proprietary trading by US banks. I was invited by the legislative counsel for Sen. Jeff Merkley, one of the architects of the original Volcker Rule bill, and a lobby group called Americans for Financial Reform.

Having read The Devil’s Derivatives, they wanted me to take a look at the detailed version of the Volcker Rule as proposed by the US regulators charged with implementing it. They wanted me to talk about how financial innovation might find ways round the rule, as had happened with other well-intended financial regulations in the past.

In my presentation, I pointed out some loopholes in the Volcker Rule: repo trading, securities lending and spot FX and commodities trading were three examples. Perhaps more dangerous than these three was the portfolio hedging exemption. That allows a single transaction on one side of the trading book to hedge a portfolio of positions on the other. That allows a great deal of hidden proprietary risk to be taken, and was responsible for billions in synthetic CDO losses during the crisis. Although the Volcker Rule tries to eliminate this possibility, the burden on regulators is considerable.

However, the key people I met in Washington DC last week are aware of these issues. Merkley, his Volcker Bill co-architect Sen. Carl Levin and their staffers are trying to close the loopholes and tighten the rules before they come into force. It’s no surprise that investment bankers in the US loathe them with a passion.

Now let’s return to Barclays. The closest thing the UK has to a Volcker Rule are the recommendations of the Independent Commission on Banking, which calls for the ring-fencing of retail banking from commercial banking, investment banking and everything else. For Barclays, which earned about 15 percent of its 2010 revenues from UK retail banking, the recommendations if implemented would be irritating, but they would not be catastrophic. Businesses on the non-retail side of the fence at Barclays would carry on pretty much as they do today.

However, if Barclays switched jurisdictions to become a Fed-licensed bank holding company, the Volcker Rule would apply. Given the relative importance of investment banking to Barclays as a group, the impact of the kind of toughened Rule envisaged by Levin and Merkley would be far more challenging. Better to remain outside of the US and avail oneself of the foreign bank exemption to the rule.

If I was in Diamond’s shoes, I would have made a rational choice as chief executive to keep Barclays in the UK. I accept that this is a question of probabilities. It’s possible that the final version of the Volcker Rule will remain riddled with exemptions. And it’s also possible that the UK law implementing the Commission’s recommendations will be tougher than what Sir Paul Vickers envisaged. Having seen the UK lawmakers in action, and comparing them to Levin and Merkley with their grasp of detail, I wouldn’t bet on it.

Given that Barclays has a balance sheet roughly equal to Britain’s annual GDP, I suspect that the Treasury would prefer to leave the investment bank powerhouse alone, and it might well act to protect Diamond’s franchise from Brussels interference. So Diamond does not have a regulation problem. He does have an image problem, hence his BBC lecture, and his preposterous assertion that British economic growth relies on Barclays’ £1.5 trillion risk-laden balance sheet. The unanswered question is: does the UK have, or will it have in the future, a Barclays problem?

You’ve seen the movie. Some bankers become the proud parents of a new-born financial instrument. At first, little CDS seems like everything a parent could want – a hedge against the downsides of middle-class existence. But as CDS gets older, disturbing signs appear. CDS is too knowing, too negative – focused on the financial death of companies and countries, left cold by the positive, socially useful side of finance. Told in flashbacks, the movie hints at some terrible denouement, the ‘credit event’, where CDS shoots deadly arrows into the fragile heart of the financial system. There’s edgy camerawork, eerie music, flashing police lights: you know it’s going to be horrific.

Small wonder that countries keep getting bailouts, bankers get strong-armed into accepting ‘haircuts’ on their sovereign debt exposure – anything to prevent the dreaded ‘event’. Greece is a case in point. Financially speaking, the country is on life support. Its bonds smell as wholesome as Muammar Gaddafi. Allowing the Greeks to default on their debt, including that owned by the European Central Bank, would be an act of mercy. Politics dictates that this can’t happen, and one of the bogeymen trotted out to justify the politics is that event in which our scary CDS devil-child shoots its deadly arrows.

It’s not so much the face-saving deceit of this argument that bothers me. One expects nothing less of politicians.

Let’s start with the premise that the much-trumpeted deal between EU governments and the Institute of International Finance for a 50 percent haircut on Greek debt prevents financial Armageddon. If enough bondholders sign up to this deal, it will be deemed ‘voluntary’, meaning that CDS on Greece can’t be triggered and the dreaded event is postponed. Now I buy into the idea of Eurozone financial institutions not triggering contracts that protect investors for political reasons. Take this one for Germany, Deutsche Bank shareholders; bend over for La Patrie, Societe Generale and BNP Paribas shareholders. However, I don’t believe for a minute that the likes of J.P. Morgan’s Jamie Dimon would agree to something detrimental to his investors in order to keep Angela Merkel and the IIF happy. Dimon has already spent too much time on earnings calls talking up the CDS hedging of his bank’s sovereign exposure to reverse that position.

But fine. This is a movie, so let’s pretend that all the world’s financial institutions agree not to trigger sovereign CDS contracts on Greece, or Italy for that matter. According to some commentators, that’s game over for CDS. These are ‘insurance contracts’ that now won’t pay out, according to the boilerplate definition used by many journalists.

In the movie, it was a catastrophic misunderstanding by the parents of the problem child that led to catastrophe. And here, it needs to be said, CDS are not ‘insurance contracts’. They are mark-to-market derivatives, 90 percent of which have collateral posted against market moves, according to the International Swaps & Derivatives Association. As a result, in 2008 Goldman Sachs was able to suck money out of AIG until it almost went bankrupt. And in 2011, that’s the point to make about Greece: if you bought protection a couple of years ago, you’ve already seen that mark-to-market gain. You already have your collateral.

Suppose you’re a credit portfolio manager at Deutsche Bank and Josef Ackermann tells you that Greek CDS won’t be triggered. What do you do? You close out your Greek CDS contracts (the easiest way is to sell protection equal to the amount you have already bought) and keep the collateral, booking the profits against losses on Greek debt. There are plenty of people willing to do that trade, people who don’t believe that a 120 percent debt-to-GDP ratio is going to save Greece. A trading desk I spoke to last week was busily matching up these buyers and sellers.

That’s how CDS work. Is it a good thing? Maybe not. If everyone knew that they would have to take a haircut on their bonds, rather than collect on their hedges, maybe they would have enforced market discipline earlier. Maybe if the Basel Committee for Banking Supervision had fixed Basel III banking rules so that CDS risk mitigation didn’t qualify for capital relief, there might be a meaningful discussion today. But that discussion isn’t taking place. If we’re going to talk about CDS, we need to understand them first.

How do you turn uncertainty into safety? The euro was supposed to replace the uncertainty of doing business between multiple countries with a single economic entity, so safe that its members could borrow money close to the price paid by the strongest, Germany.

One good thing about financial markets is that they put a price on uncertainty. In hindsight, the multiple currencies and interest rates of pre-single currency Europe had an advantage because they forced people to do their homework; market governance was better than political governance, which is why many politicians hate financial markets.

Prior to the advent of the euro in 1999, the market’s verdict on countries like Italy and Greece was that they had to pay interest rates in the low teens – the price of their perceived profligacy compared to northern Europe. In my first book, Inventing Money, I wrote about how Italian officials brought in Wall Street banks and the hedge fund Long-Term Capital Management to contrive a squeeze in Italy’s bonds, driving up prices and turning convergence with Germany into a self-fulfilling prophecy.

Former LTCM partner Eric Rosenfeld later told me that he was so dubious about Italy being accepted into the Eurozone that he bought credit default swap protection against Italy going bust (LTCM ended up going bust instead). Once the euro was up and running, this kind of healthy scepticism got replaced with blind faith that the deficit and GDP rules crafted in Maastricht would prevent the new low interest rates from going to peoples’ heads. Those rules soon became a formality that Eurozone countries could ignore with the right paperwork.

That was the essence of the swap deal that Goldman Sachs did for Greece, concealing debt using a derivative that exploited a loophole in the accounting rules. Writing about this deal in 2003, I was struck by how Greece’s breaches of the rules were insulated from market scrutiny by the feel-good politics of the Eurozone. Unimpressed, Goldman secretly hedged its risk by buying CDS protection on Greece, making the Greeks pay for it.

Today, the politics of the Eurozone is itself a source of uncertainty. The market scrutiny that has been missing from the Eurozone since 1999 has returned with a vengeance, blocking the peripheral nations from access to funding and threatening Italy, Spain and even France. The bloated banking groups that grew during the euro’s heyday are also losing funding access, and need to be recapitalised.

With their system’s internal governance discredited, the Eurozone’s leaders have no choice but to create financial mechanisms that provide markets with a transparent substitute for that faith in single-currency politics they once had. These mechanisms, such as the European Financial Stability Facility, are supposed to fund the weakest members of the Eurozone without looking like a bailout – a simple transfer of money from strong to weak — which would be politically impossible.

The EFSF has been described as a collateralized debt obligation, which it has not been up to now because it doesn’t tranche or layer its risks. Recent proposals for a leveraged EFSF talk about it as a bank or insurance company, or even giving it formal CDO status. All these financial mechanisms share in common the concept that leverage applied to loss-absorbing capital delivers low-cost funding for a pool of risky assets. The EFSF’s hundreds of billions in capital are not enough on their own to lower funding costs for Italy and Spain, and backstop the Eurozone’s banks, but if they absorbed the first 20 percent of losses on these trillions of liabilities, that might do the trick.

This will turn strong-country taxpayers into equity holders in a portfolio of weaker Eurozone countries and banks. That’s the place the private sector doesn’t want to be (although there is talk of inviting Asian sovereign wealth funds to participate – good luck). If the leveraged EFSF comes to fruition, it may be because Eurozone taxpayers don’t have the tools to price the risks that their political leaders are taking in the way that financial markets can.

We don’t know the full details of how Kweku Adoboli lost $2 billion at UBS, but as I watch an industry in decline, an analogy springs to mind. Yesterday I had a long conversation with one of the former managers in the chain of command above Jerome Kerviel at Societe Generale. After losing his job in that debacle, he’s now a top trader at another bank.

After we had got through the formality of exchanging the phrase ‘déjà vu’, my friend recalled the lessons he had learned from Kerviel: the need to have an army of people in place checking and re-checking the minutiae of a large trading operation. “It’s a long list”, he said, reeling off the tasks involved in reconciling pricing and cash payments across a web of counterparties in listed securities, over-the-counter equity swaps and stock lending portfolios. For example, just to confirm that the documentation of a trade and its ostensible hedge have the correct timings to avoid multi-billion mismatches is a full time job.

I once visited a floor of people that did this for a living. At first sight it looked like any other investment bank trading floor, although slightly shabbier since it was a floor that clients and most journalists never saw. These people easily match the numbers of “front office” staff at investment banks, and if you want to cut costs at a bank, you have to cut them too.

Now think of what happens if you attempt to trim these overheads while trying to increase the profits generated by the remaining employees. That means competing more aggressively to launch exchange-traded funds, increasing the volume of derivatives and securities trades that have to be reconciled behind the scenes. If you look at market share and the size of its balance sheet, it would appear that UBS has been doing just that.

“More instruments, more complexity – that means more risk”, as my friend put it. He mentioned the Japanese earthquake and tsunami as an analogy of an extraneous shock that could overwhelm the safety systems you had in place. I quibbled with him over that – in banking, market volatility is generated by the banks’ drive to increase volumes, not natural phenomena.

It was the echo of the Fukushima nuclear plant that got to me. Those floors of “back office” or “middle office” staff are like the cooling water being pumped into a reactor. Don’t be surprised if reducing the flow contributes towards a meltdown. To achieve a “cold shutdown” of a typical bloated investment bank, the costs could be much higher than we think.