“It’s a situation where you have not got any really concrete evidence: one piece, like a CCTV camera footage or a witness, etc, all you’ve got is an accumulation of basically very low-level evidence — coincidences, etc — but when you actually accumulate a large number of these [using] something called a Bayesian analysis, it’s actually more statistically sound to have 100 little arrows pointing towards Lucy and none pointing away from her, and I think that’s how justice was actually reached.”

—Criminologist David Holmes on Sky News, 18 August 2023

“Nothing happens in Moscow.”

And so then I just ran down there and we talked and we just locked the door. We didn’t think anything of it. We’re like, “Nothing happens in Moscow”.

—Eyewitness statement to police, 22 November 2022.

Moscow Idaho, a small town in northwest America, is known principally as the home of the University of Idaho, and not a lot else. Almost three hundred miles upstate from the capital at Boise, it is remote, quiet and — usually — safe. Before 2022, the town had not recorded a single murder in seven years.

Remote, but not isolated: eight miles east, across the state line, lies similarly-sized Pullman, Washington. Pullman, too, is safe, remote and similarly academic: it houses the Washington State University campus.

That quietude was broken in the early hours of November 13, 2022 when a masked intruder entered an off-campus student house in Moscow and brutally murdered four University of Idaho students, stabbing them as many as 150 times, before disappearing off the planet’s face.

No-one called the police for 12 hours after it was clear the murders had taken place. Still, there were no obvious suspects. The victims were ordinary, outgoing, sociable kids. They had no known enemies. They weren’t dealing drugs. They were not caught up in any kind of vice or skulduggery that might explain such an awful.

Three lines of enquiry

Local police, unused to antisocial crime, found themselves facing unprovoked, inexplicable, mass-murder. There were three broad lines of enquiry: there was an eyewitnesses, forensic evidence the killer may have left behind in the house and CCTV footage of the surrounding area.

Eyewitness

The eyewitness, a housemate, didn’t see much: she briefly glimpsed the assailant before locking herself in her room:

“I saw this guy, and he was not insanely tall, but he was wearing all black and, like, this mask covering his forehead and his mouth.”

Crime scene

As for the crime scene, the perpetrator could be associated with just one item: the sheath from a “Ka-Bar” combat knife — though not the knife itself — recovered from the bed of one victim. It contained a spot of unidentified DNA.

Despite the fury of attack, and evidence some of the victims had put up quite a fight, police forensics found no other evidence of the perpetrator.

CCTV

The CCTV revealed one thing of note: a white car, repeatedly captured driving back and forth around the crime scene at the time of the murders. No other vehicle appeared on the cameras during the period of the murders at all.

Though much car footage was of poor quality — little more than a smudge of white behind a frame burned out by headlights — police forensics were able to triangulate and sequence the images to match a much clearer image caught on a camera further down the road. They narrowed it down to a white, early 2010s Hyundai Elantra.

There was no clear picture of the driver. No one was filmed getting in or out. The Elantra may have had nothing to do with the murders, but it was there, apparently circling the crime scene, and when it finally departed, it went with engine racing and tyres squealing. There aren’t many cars on the road in the dead of a cold night in small town Idaho. If the Elantra wasn’t involved it needed at least to be ruled out.

Moscow Police put out an “all-points bulletin” on the Elantra. No-one came forward. They combed local vehicle registries in the Moscow/Pullman area and polled campus police at both universities. They turned up about 100 white Elantras. None looked especially suspicious.

Forensics

Police went deeper into the forensics. They found some some DNA on the “Ka-Bar” sheath. It did not match the victims. It did not match their housemates. It did not match any records in FBI database. If it belonged to the murderer, he had a clean record.

Police uploaded a “single nucleotide polymorphism” profile from the DNA to a couple of consumer ancestry websites and got a small number of hits for distant relatives.

The police triangulated. They narrowed the DNA down. The perpetrator hailed from somewhere deep in Pennsylvania. This was good and bad, news.

Good news: it was a narrow region. Bad news: it was more than 2,500 miles from Moscow, Idaho. It could hardly be further away. It looked like the police had an evidential disconnect: murders in the remote northwest, by someone from the remote northeast.

A tailgating Hyundai Elantra

Two weeks later, on Interstate 70 outside Greenfield, Indiana — that’s nowhere near Idaho or Pennsylvania — police twice pulled over a white 2015 Hyundai Elantra, for “tailgating”.

The car was on Moscow PD’s list. At the wheel was Bryan Kohberger, a doctoral candidate in criminology at WSU Pullman. Kohberger was with his father. They were on their way home from Washington for the Winter holidays. It was a 38-hour drive.

“Home” was a small town called Albrightsville. Albrightsville was deep in Eastern Pennsylvania, right in the middle of that narrow region identified by DNA triangulation.

Bryan Christopher Kohberger became the prime suspect. The began investigating him in earnest.1

A FBI team went out to Albrightsville to comb the family’s trash for DNA.2 They snagged some Q-tips. They got a match. Investigators checked out Kohberger’s Amazon purchase history. It revealed: he bought the very model “Ka-bar” knife that matched the sheath just months before the murders.

But the car was clean. An FBI forensics team tore it apart, panel-by-panel. They found nothing: no blood. No crime scene evidence. They found nothing in his residence. Given how frenzied the murders were — stabbings, at close range, with struggling victims — you would expect the perpetrator to be covered in blood. But there was no sign of it, if so.

The policed pulled cellular phone data. Kohberger’s phone “pinged” a GSM tower in Pullman before the murders, then went “dark”, then came back on line — pinging a tower much closer to Moscow — after the murders. The police said this was consistent with Kohberger being away from home — on the road — at 3 am and then then switching off his phone, as if he wanted to “go incognito” for a while.

Kohberger denied switching off the phone: he told police he had been “star-gazing” alone. He said he must instead have been outside cellular coverage as he drove into rural Idaho in search of the cosmos.

Arrest

The police thought they had enough information to convict him and, on December 30, 2022 arrested and charged Bryan Kohberger with four counts of first-degree murder and one count of felony burglary. Prosecutors announced they would seek the death penalty. As is evidently common in Idaho, Mr. Kohberger “stood silent” to the charges, and a plea of not guilty was entered on his behalf.3

After his arraignment the defence made several unsuccessful applications to the court to have the death penalty taken off the table. After six months’ of reversals, Kohberger’s team proposed a “plea deal”: in return for pleading guilty, Kohberger would accept four consecutive life sentences and would avoid the death penalty. Against his victim’s families wishes, the police accepted the proposal. Kohberger was sentenced to life in prison. The criminal trial never took place.

And there, but for the inevitable cascade of mediocre TV documentaries4 it might have ended, had not Bryan Kohberger moved, on 27 July 2026, to withdraw his guilty plea on the grounds that it was made, on defective legal advice. It is not clear yet whether the State of Idaho will allow this reversal, but if it does he will be tried, and the families may yet have their day in court.

Idaho has, since his original sentencing, reintroduced the firing squad.

Circumstantial evidence and the small arrows

And this is where Ms. Letby’s case comes in. For, not unlike Ms. Letby, Mr. Kohberger has attracted a body of opinion — though appreciably smaller — that he, too, is innocent. This is based on superficially similar grounds: there is little solid direct evidence that it was him. The one eyewitness identified a masked man with “bushy eyebrows”. Mr. Kohbergber’s eyebrows do not seem especially bushy. The DNA evidence, though appearing compelling, is oddly isolated to a single artefact. It is vulnerable to “chain of custody” issues. It is vulnerable to skulduggery: it is not impossible that this single item was planted to “frame” Mr. Kohberger.

The remainder of the evidence against him is circumstantial and what Professor Holmes might call “low-level”: it is only when taken together with other “little arrows” that it starts to point at Mr. Kohberger. His supporters say that it has been deliberately marshalled and framed so to as to create a misleading impression of his guilt.

Ms. Letby’s case is also founded on circumstantial evidence. Her supporters say much the same thing. It is a useful point of comparison.

By way of reminder, “circumstantial evidence” is not eyewitness or CCTV evidence of the deed being done — there is often no such “direct” evidence of unprovoked murder — but rather is evidence surrounding the allegations that invites the jury to infer what happened. Circumstantial evidence is evidence that the crime is more or less likely to have happened. It is inherently probabilistic.5

The prosecution must prove two things: that it was murder; and who the murderer was.

In Kohberger’s case, almost all the circumstantial evidence concerned that second question. In Ms. Letby’s, almost all concerns the first.

That it was murder

Here there is another interesting similarity between the cases: as causes of death go — even death by murder — both are are extremely unusual. You are most unlikely to die by unprovoked mass-murder by a stranger with a hand-held blade.6 You are even less likely to succumb to a healthcare serial murderer.7 Both are extremely rare events.

So before moving onto whodunnit, prosecutors must first satisfy the court that there were murders at all. If the evidence about that is at all flaky, they face an uphill battle to get a conviction.

And here, the similarity between Moscow, Idaho and the Countess of Chester Hospital’s neonatal intensive care unit ends.

For in Idaho, there was no chance the victims died of “natural causes”. No-one argued for a moment — not state prosecutor, not public defender — that these were not murders.

If you know an event has happened, it does not matter how unlikely it was in the abstract. Probabilities only help you resolve intrinsic uncertainty, about things that haven’t happened yet, and anecdotal uncertainty, about things that have.8 Here there was neither kind of uncertainty. The only question the state prosecutor needed to answer was whodunnit.

Ms. Letby’s case was different. Multiple health professionals had attended each collapse. Not one suspected malice at the time. The crown prosecutor needed to satisfy the court, beyond reasonable doubt, that these collapses were the result of malice. Almost all the medical evidence — relating to air embolus, insulin, endocrinology, radiography — was directed at that question. It was not about Ms. Letby, but murder in the abstract. The deficiencies with it are legion — I have covered them at length elsewhere — but they are not relevant here.

The evidence relating to the second question — whodunnit — was quite different.

Whodunnit

The “who” profiles for the Idaho 4 and for the Countess of Chester were vastly different. In Idaho, anyone within a reasonable travelling distance of the crime scene could have perpetrated this murder. About 160,000 people live within 50km of Moscow.9 That’s a big haystack.

By contrast the number people who could plausibly commit murder in the Countess of Chester Hospital — access-authorised employees — is institutionally bounded. They can quickly be triangulated down, just by who was there and when. So, for healthcare serial murder if you can satisfactorily answer the “that” question, the “who” question tends to answer itself.10

The very rarity of unprovoked stabbings tells us that, although many people could physically commit them, very few are likely to actually do so. The “plausible suspect pool” is much smaller than the population at large.

Even if the haystack contained that starting 160,000 people — it would quickly triangulate down to a much smaller number than that — we would not expect to find more than a couple of plausible suspects to carry out.

This presented Mr. Kohberger’s defence with a problem. The “that” was granted: the four students were definitely murdered. But Kohberger was not merely a “random draw” among 160,000 citizens of the northwest. He had been found: he fitted the offender profile, had the opportunity, and was linked by physical evidence. His problem was explaining how the investigation could have matched all the circumstantial features and yet still converged on a wrong person.

If Ms. Letby’s “that” was satisfied — if the crown could satisfy the court that there had been a series of murders — Ms. Letby had the same problem: assuming the collapses were murders there was, as Professor Holmes put it:

An accumulation of basically very low-level evidence — coincidences, etc — 100 little arrows pointing towards Lucy and none pointing away from her

It is worth comparing Mr. Kohberger and Ms. Letby in more detail.

In Mr. Kohberger’s case, the evidence is low-level, but discriminating, in the sense that it discriminates against him: each additional piece adds meaningfully to the factual matrix comprising the sum total known about the night of the murders. The evidence correlates and corroborate sin fairly direct ways. Mr. Kohberger owned an Elantra and cell data indicated he was driving it at the time of the murders.

This reduces the possibility that an alternative defendant will emerge exhibiting stronger evidence, in turn making the odds that Mr. Kohberger was simply an unlucky innocent, in the wrong place at the wrong time, increasingly remote.

This is what Professor Holmes means when he talks about a “cumulative Bayesian analysis”: each new fact meaningfully updates the known factual scenario. Likelihoods get higher. Probabilities move away from their abstract “base rates” — whereby Mr. Kohberger is an average citizen, no more likely than anyone else to be the murderer — to an updated “posterior” in which he is quite a lot more likely to be involved than a random person.

After all: it is one thing to simply live in the general area. It is another to own a white Elantra: hundreds did that. But living locally, owning an Elantra and being out and about in it at 3am on the night of the murder: that is unfortunate. And happening to lose cell connection just before the murder, and regaining it just after — that is accursed.

And that is before we even get to the DNA-covered sheath. It is a single piece of evidence, true — but it was recovered on the first day of the investigation. If it was planted, then whoever did that must have already had Mr. Kohberger in mind, known that owned such a knife, that he drove a white Elantra, and would be inexplicably out in it, beyond cell range at just the moment of the attack. The probabilities of this being staged seem low. For this to represent a reasonable doubt, Mr. Kohberger will need to produce a plausible master, murderous antagonist, bent on fitting him up.

For all Professor Holmes’ assurance, this is not like the circumstantial evidence brought against Ms. Letby. Except for one aspect — her very presence, and we will come to that — the circumstantial identification evidence is ambivalent. It does not progressively exclude alternative explanations. Much of it is nothing like contemporaneous. It is evidence capable of being interpreted consistently with either guilt or innocence. A sympathy card to bereaved parents, for example, is equally compatible with a guilty person attempting to appear normal and an innocent colleague expressing genuine sympathy. Likewise, apparent opportunism can be characterised by the prosecution as a murderer exploiting opportunities, but by the defence as behaviour inconsistent with a premeditated serial killer.

Mr. Kohberger was confronted with a plausible case around him with a lot of quite-hard-to-explain, inconvenient circumstantial evidence. To be sure, he offered explanations: he said he drove his white Elantra across the state line into Idaho on an overcast night to go stargazing, alone, at three in the morning and out of cellular range — at just the moment four students were being murdered in the rough vicinity. Each taken, by itself, seems unlikely but not impossible — but for all to be true at once, seems outlandishly improbable. If it wasn’t him, Mr. Kohberger is a galactically unlucky man.

Of the evidence in his favour, while it might seem likely that a violent intruder would leave some fingerprints or DNA traces at the scene — Mr. Kohberger did not — and so their absence apparently supports his story, an eyewitness described an assailant in a ski-mask, and a pair of gloves were recovered from Mr. Kohberger’s car. These facts dilutes the value of this missing evidence. The suggest an assailant who has taken proactive steps to avoid leaving evidence.

There are competing probabilities here: On one hand, there is probability of an actually-innocent person being out in a white Elantra in the rough vicinity and at the precise moment such a car is involved in a statistically improbable murder; on the other, there is the probability that the perpetrator of that crime would take positive steps to destroy evidence before police can find it.

The same is not true of the circumstantial evidence offered against Ms. Letby. Much of it is equally consistent with innocence as guilt, and not especially probative of either. While it might be self-serving for a murderer to bemoan her own misfortune at always being on deck when a collapse happens — but, Q.E.D., you would expect exactly the same reaction from an innocent: that is exactly why it would be “devious” behaviour. And where the little arrows in Ms. Letby’s case point anywhere at all, they tend to be discrete: they do not have a cumulative effect the way a white Hyundai outside of cell-tower range, in the dead of night, at the time of the murders does.

And there was a lot more opportunity to collect real-time evidence about Ms. Letby: she was operating in a “data-rich environment” under at least informal suspicion11 for months before the final collapse for which she was charged. The weakness of the identification evidence ultimately presented against her — barring her “constant presence” — tells its own story.

The constant presence

And this brings us to the last strand in this circumstantial case against Ms. Letby, and in my view the most important: her opportunity. If this one falls, all else falls beside it.

As noted, “mere presence” does not address the “that” question: whether any murders happened at all. The staff attendance record is relevant only to the second question: given that there were murders, “whodunnit?”

We would expect an attendance record more easily rule out potential suspects than implicate them: those who weren’t in the building can hardly have been the villain. Just being in the building is not, of itself, positive evidence of malice.

But given the small total pool of suspects — fewer than 50 people were authorised to be in the Countess of Chester’s neonatal ICU at all — that ruling out process is likely to boil the set of prime suspects down to a very small number: in the Countess of Chester’s case, almost certainly just one.12 If you do know there is murder, and only one member of the staff has the opportunity, that person is in the headlights.

This is identification by elimination, Sherlock Holmes style:

When you have eliminated the impossible, whatever remains, however improbable, must be the truth.

Weed out staff members were not present for every collapse. The group that remains contains your perpetrator. With a fair wind, it will be a group of one.

Event selection

But there is a danger here of being lulled into “categorical blurring” and using a nurse’s mere presence to buttress weaknesses in the evidence for murder in the first place.

Remember, the prosecution must prove two distinct propositions:

1. That: The collapses were the result of deliberate acts by someone

2. Who: Ms. Letby was that someone.

While both questions may in theory be discharged by the same facts — a direct eyewitness catching the murderer red-handed would do it — they are nevertheless logically distinct: both must independently be proven. There is a danger of taking proof of presence as proof of murder.

The danger lies in plumping for identification via the Sherlock Holmes method before you have earned the right to use it.

Here is how it might happen:

Say the forensic evidence of murder is a bit underwhelming. You’ve done your best, but the strongest evidence that there were any murders — if you squint a bit — comes from a couple of cases the hospital only threw in at the last minute to make up numbers. Sure, there’s an arguable case for murder — air embolus, immunoassays and whatnot — but none of it is overwhelming.

Nor do any of the cases in isolation stand up as definitive provable murders by anyone, let alone Ms. Letby. Instead, they seem, spookily, to bolster each other, when collected together generating a sort of emergent credibility they don’t have when taken individually.

Though the case for murder is underwhelming, you run your “Sherlock Holmes” analysis on the staff records anyway. Hey presto: thar she blows, standing out in a row of grim black crosses: the angel of death. Twenty-two events, twenty-two crosses, and no-one else even close.13

The CPS nixes the idea of calling a statistician, but you don’t need one to see that the chance of this happening by sheer coincidence is off-the-scale unlikely — way beyond the scope of any “reasonable doubt”.14

This is where the confusion comes in. The “Sherlock Holmes reduction” becomes evidence not just identifying the murderer but supporting the hypothesis that they were murders in the first place. Just as it is off-the-scale unlikely that one nurse would be present by coincidence at twenty-two random events, so it is off-the-scale unlikely that unexplained collapses would happen by coincidence on twenty-two random days. If the data are fair, you shouldn’t therefore need compelling evidence of murder: the improbable coincidence does that for you.

This feels a bit of a sleight of hand, but it need not be, as long as the samples are both fairly — that is to say, independently and without regard to any “theory of the case” — drawn. If so — and if Ms. Letby’s presence was no kind of filter to eligibility as a suspicious collapse — if this is the totality of all unexplained collapses that occurred in the suspect period, defined by reference to independent criteria, and the attendance records are indeed comprehensive — then presence alone may be probative — strongly probative — of murder. The “who” also answers the “that”.

The problem for the prosecution — and now, for the defence! — is that they may not have been independently selected. That might not have even been possible. The selection criteria are paramount. If it turns out that the 22 collapses were chosen because they took place when Ms. Letby was on duty, the constant presence is not a statistical outlier, but a certainty. The “Sherlock Holmes” method works for neither “who” or “that”.

So, how were the 22 collapses selected? We don’t know. Ms. Letby’s defence applied to the court for disclosure of how the prosecutor selected the charges for which she was prosecuted.

The prosecution objected.

As it often did, over the nine-month trial, the court declined the defence application.

And thereby hangs a tale.

Kohberger and Letby, redux

Mr. Kohberger’s and Ms. Letby’s cases could hardly be more different, but both being in the public eye they make for a good comparison. I hope you found reading this exercise as enlightening as I found researching it! If you did, please share it.

It’d make a great play.

Shithousery
/ˈʃɪthaʊsəri/ (n.)

Poor, but not unambiguously illegal, behaviour, especially in competitive sports. Disruptive or underhand tactics intended to gain an unfair advantage.

Aboyne
/əˈbɔɪn/ (v.)

To beat an expert at a game of skill by playing so appallingly that none of his clever tactics or strategies are of any use to him.

—Douglas Adams & John Lloyd, The Meaning of Liff

Prelude: the final

Against all expectations, not least of which yours, you are in the grand final. Things broke lucky: you had a good draw, your opponent in the quarter-final tore a hamstring and in the semi-finalist had an off-day, you got the bounce of the ball and somehow prevailed, and here you are. They’re singing the anthems, but you know you’re up against it. Your opponent is the reigning champ: younger, taller, faster, fitter, and more skilful, in every facet of the game. Just hands-down better. In a straight shootout, you don’t stand a chance.

There’s one arrow in your quiver, but even that’s bent: you’re crafty. Streetwise. You’ve got game.

So what are you going to do? Just sit there and take a pounding?

Now, where would be the fun in that?

The 2026 FIFA World Cup Final

There was an extraordinary moment towards the end of the 2026 FIFA World Cup Final between Spain and Argentina. It was missed by the television cameras, VAR, and all of the little accelerometers embedded in the $1200 ball.

It was captured, accidentally, on an iPhone by a fan standing high in the stands behind and to the left of Argentina’s goal in the second half, as he filmed down the ground toward the Spanish end. Regulation time was over. We were three minutes into an alloted four minutes of stoppage time. It was nil-all and extra time was beckoning.

@bill_mahmuud @bill_mahmuud ♬ son original - Papa Mahmoud Gueye

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Having just lost an aerial challenge, Argentina’s Enzo Fernández sprints to recover the ball as Spanish defender Pau Cubarsi comes out to compete for it. Cubarsi gets there first, on the halfway. So late, and so poor, is Fernández’ challenge that Cubarsi is catapulted spectacularly into the air. Referee Slavko Vinčić immediately shows Fernández a yellow card — really, it should have been a straight red — but since Fernández has already been booked, he is sent off anyway.

But this is not the interesting incident. Twenty-five metres behind the tackle, the iPhone catches Argentine left back Nicolás Tagliafico watching, unengaged in the action, a good ten metres from any other player. Closest, in fact, is referee Vinčić, but he, like everyone else has his back to Tagliafico, mesmerised by Cubarsi’s dramatic rear somersault.

Within an instant — literally, before Cubarsi has even hit the ground, which he does in a tremendous heap — Tagliafico collapses, waving his legs in the air and clutching his knee, for all the world like he has been felled by a huntsman’s axe. No Spaniard is near enough by to even bother protesting innocence. No-one touched him. There is no-one within cooey of him, who even could have touched him. Tagliafico — a painted ship upon a painted ocean — writhes and gurgles, as if his Earthly struggles are at an end. It is perfectly absurd. At first, with all the other commotion on the pitch, no-one even notices.

Like everyone else, the iPhone zooms in as the referee strides towards Fernández — already vainly protesting that is all some ghastly misunderstanding — and brandishes the succession of cards. Indignantly, Fernández refuses to quit the field.

The prone Tagliafico is now out of shot, but enter Argentina’s captain Lionel Messi. He marches from the Spanish half toward the referee — the farthest and fastest he moved all day — motioning towards Tagliafico. Even now, only 13 seconds has elapsed since Fernández’s foul. Messi remonstrates with the referee, repeatedly gesturing towards Tagliafico, for another fourteen seconds.

To his credit, Vinčić does not buy it for an instant. We cannot see what happened to Tagliafico in the meantime and no other cameras appear to have captured it, but the BBC’s interactive 3D match experience does capture it. You can highlight Tagliafico, zoom in on him, and watch him roll around until, apparently, being told to stop by the linesman.

Though it failed, this is still shithousery of the highest order. To apprehend a scenario and so quickly react to it requires not just presence of mind but instinct. You cannot learn this.

Likewise, from Messi: to even notice Tagliafico, some fifty metres away the other side of an explosion of action is a testament to the maestro’s unparalleled vision and game awareness. To read and comprehend his signal as astutely as he does suggests spooky entanglement. It speaks to a deep, innate feel for the game, and all the means of prevailing, fair and foul.

For deep shithousery.

Some have this, some don’t. Argentina has it. English teams, by and large, don’t.

“Shithousery”?

Shithousery is gamesmanship: to play just within the rules—or in the unspoken voids where there are none, or even against the rules—but in the certain knowledge you will get away with it. To “shithouse” is to infringe morally, but not legally. You most often see it in sports but is just as common in politics and business.

To shithouse is to sledge. To dive. To run down the clock by taking the ball to the corner flag. But also to grandstand. To take credit for someone else’s work. To brown-nose the boss. To impugn. To ask, “have you stopped beating your wife?”

It can go wrong. Following media reports of child abuse linked to an unidentified Tory official, plainly thinking it an excellent piece of shithousery, Sally Bercow tweeted to her 50,000 followers:

Why is Lord McAlpine trending? *innocent face*

This impugned the conservative peer with the ostensibly plausible deniability of an open question that was only loaded for those plugged into British political minutiae — but when it proved unfounded, Lord McAlpine successfully sued.

In any case, shithousery is inevitable, whenever we fix rules in advance with arbitrary limits that do not carve nature at its joints. Rules that presume all actions are witnessed, and all players have honourable intent. But referees are unsighted. Touchlines are arbitrary. Less gifted players do what they can to win: they do not always play fair. If you’re facing an overwhelming opponent, sometimes you have no choice.

Preconfigured rules of the game are blind to this “underdog’s dilemma”. They presume each team will continue to press for goal until the final whistle, but sometimes keeping the ball from the opponent, however you can, is all you need to win.

In a sense, going a goal up and parking the bus is a form of shithousery.

Each year governing bodies — of sport and in life — realign the rules to shut down newly discovered routes to the shithouse, but the scope for imaginative gamesmanship passeth all understanding. It is, in any case a forlorn task: to shithouse is, in a sense to exploited misconceived rules. No rules have more misconceptions than new ones.

We may not, therefore, like shithousery, but we are stuck with it. This article makes the case that, instead of righteously disdaining it, when confronted with it, we should return the favour.

Shithousery as tactic in a finite game

By taking their shithousery to a different level, Argentina demonstrate how finite games — competitive, bounded, zero-sum games like football — are most comfortably won at the margin of legality.1 Argentina may not have won the World Cup this time, but they have before, and they got a good deal closer here than, by rights, they ever should have.

They did this not by being good, but bad. This is not a criticism. It is a fact of life, and “good” teams need strategies to cope with it. One strategy is to reply in kind.

As in business and life, there are “formal” and “informal” modes of play. Formal ones we can see, and track, and record: goals scored, tackles made, possession and territory held, passing accuracy and so on. But they can paint misleading pictures.2 “The data” absolutely fail to explain why Spain could not wrap up the game in the first 20 minutes.

Spain plays beautiful, elegant, rational, orderly football. Their players are settled, stable, calm, and efficient. They don’t panic. They press high, tackle cleanly, and make good shapes.

Argentina did little of any of this. They were awkward, disorderly, disruptive, destabilising and chaotic. They were pugilistic from the first whistle. They left in elbows and studs and risked bookings — and until the 93rd minute got away with it. Spain were good. Argentina were bad.

Here is what I mean by “good” and “bad”:

The same goes for England in their semi-final. By this measure of good and bad, England were at least as good as Argentina — but the South Americans were on a different level when it came to being wilfully bad. Argentina never really looked like losing, even when a goal behind, and even though they never led until deep stoppage time.

For, despite the obvious chasm in formal quality between the teams — you did not need to be Franz Beckenbauer to see it — still Argentina got within 14 minutes of a penalty shoot-out for the title. And penalty shootouts, we know, are bad. They are chaotic, capricious, random, cruel, awkward, and disruptive. Be in no doubt: Argentina backed themselves to win on penalties. Argentina’s supreme, functional, effective badness almost won them a fourth World Cup.

Teams who can be good and bad are most likely to succeed. You cannot indulge the light if you do not exploit the dark.

As we will see, this concept of effective bad has a more general application.

Good and bad in politics

Warning: this section touches on contemporary politics, a subject JC tries to steer well clear of. No opinion is advanced here about any political issue. This is about behaviour and shithousery — something which some are better than others at — but over which no party has a monopoly.

Arthur: Then who is your lord?

Old Woman: We don’t have a lord.

Arthur: What?

Dennis: I told you. We’re an anarcho-syndicalist commune. We take it in turns to act as a sort of executive officer for the week. But all the decisions of that officer have to be ratified at a special biweekly meeting, by a simple majority in the case of purely internal affairs, but by a two-thirds majority in the case of more–

Arthur: Be quiet! I order you to be quiet!

—Monty Python and the Holy Grail

The same goes for adversarial politics: if you are always “good”, in the sense described above, you are predictable. If you can be anticipated, you are vulnerable to a crafty opponent who knows what you will do, keeps you guessing or cannot be trusted to do the right thing. Who is given to shithousery. This is the “craziest guy in the room” strategy.

This, by the way, is a vital difference between unbounded, positive-sum, “infinite” games, like trade and diplomacy, where both sides stand to gain by continuing to “play”, and “finite” ones, like party politics or litigation, where there are fixed rules, fixed players, a loser and a winner.3 I have touched before on finite and infinite games, a devising of cultural anthropologist James P. Carse.

“Trust” — supposing other contestants will do what they have undertaken to — is a vital component of an infinite game. In finite games, trusting your opponents to behave how you want them to is a marked weakness.

This is true within organised political systems: the success of many populist and authoritarian politicians is due in large part to their being the “craziest guy in the room”. Their range of actions is not limited by the predictably elegant, patient, rational and nuanced responses of a traditional politician, always trying to strike some kind of balance: to the contrary, upsetting the applecart confers an advantage, as “good” opponents scramble to restore order, thereby forcing themselves into reactivity, forever responding to the opponent’s moves rather than dictating the terms of the contest.

In a political finite game, exclusively “good” players risk always on the back foot.

It is even more true between organised political systems, where the rules of engagement are less clear: take the European Union: an organisation conceived specifically as a system to prevent regional international conflict: to replace the bad incentives of war with the good incentives of cooperation. The EU functions as a bulwark, too, against threats from the East. But the EU is a good organisation. It is profoundly, constitutionally, rule-making and rule-following.

Would-be antagonists, like Mr. Putin — and to a lesser extent, Mr. Trump — know this. They know exactly what the European Union will do, and what it is almost certain never to do.

For its part the European Union does not have the same confidence about Mr. Putin or Mr. Trump. It has no idea what they will do next. Nor, perhaps, do they. The more unexpected their actions are, the less confidence their “good” counterparts on the world stage can have. The range of “good” responses is therefore, for the same reason, limited. The more limited it is, the more predictable it becomes.

So the EU’s natural reaction when confronted by an unpredictable and volatile force outside its boundaries is to try to placate it, to reason with it — to strive for consensus with it, and failing that, to appeal to the rules and referees of the game. These are “good” strategies. They don’t work well against shithousery.

For, as far as there are any rules of geopolitics, they are opaque, such referees as there are are invested with meagre powers, and smart players exploit the natural opacity and ambiguity of life at the fringes of acceptable “play”. But players do not have to broadcast their real ends, tactics or strategies.

The European Union, being by nature a ruleset, does broadcast its ends, tactics and strategies, real-time, as they develop: that is a fundamental “good” of an open democracy, so it must.

The range of things the European Union can do is conditioned by an ancient, deeply regretted history of violent regional conflict, and a recent history of enlightened convergence through benign constitutional bureaucracy. The range of things it will do is tighter even than that, and is conditioned by rigorous, transparent “good” process.

European constitutional bureaucracy is absolutely supreme to “executive fiat” — there is no meaningful “leader” of the EU (the EU “president” is a largely ceremonial role that rotates between member states in a fashion strikingly redolent of an anarcho-syndicalist commune, at least as envisaged by the Pythons). The American constitution plainly (and despite many protestations to the contrary over its history!) is not really like this, and the Russian constitution definitely is not.4

The plausible preparedness to subvert “rules of engagement” is an enormous advantage in a finite political game. It may explain Mr. Trump’s surprising success in foreign policy. Mr. Putin has Western Europe “taped”, but really does not know what Mr. Trump will do, possibly because Mr. Trump does not either. Mr. Trump has, thereby, unshackled himself from the conventional bounds of U.S. Foreign policy. It is unthinkable for any European leader to do anything like that.

The EU can’t be the craziest guy in the room. It finds itself flanked, on either side, by crazier guys.

OODA loops

The OODA loop concept comes from aerial dogfighting but applies to any situation of combat where you are in a constant cognitive cycle between taking in what is happening (observing), synthesising a theory of what’s going on and what your opponent doing (orienting or synthesising), figuring out how to respond (deciding) and then doing it (acting) — ideally, before your opponent gets through her decision cycle, works out what you’re doing and changes up what she is planning to do to you.5 The OODA loop is the basic unit of combat psychology.

Combatants who can get through that decision cycle first have a distinct advantage because they can then dictate the forward terms of combat, and thereby play to their own strengths, continually changing up while their opponents are still reacting to their last move: they can “get inside their opponents’ OODA loop”.

Organisations that are by nature rule-based and process-focused are at a natural disadvantage against scrappy upstarts unless they can somehow create room inside their own constitutions for disobedient behaviour.

This has implications for data modernism.

Data modernism

I like to think
(right now, please!)
of a cybernetic forest
filled with pines and electronics
where deer stroll peacefully
past computers
as if they were flowers
with spinning blossoms.

—Richard Brautigan, from All Watched Over by Machines of Loving Grace (1967)

The current trend towards data modernism — an aspiration to “solve the world” with data and encode the future, so the human race need no longer struggle, but may lie in cybernetic meadows dreaming of electronic sheep — seems to swing ever further in the direction of a “good”, calm, solved, rational world — whilst, at the same time, the public stage fills with “bad” actors: would-be populists playing silly buggers and running rings around staid, “good” traditionalists. This is some kind of cognitive dissonance, but the message may at last be filtering through that the dark arts are still with us, and there is nothing the computers can do about it.

The upcoming Clacton-on-Sea by-election points the way.

For one way to seize the initiative from a grandstanding populist who has got inside your OODA loop is to refuse to follow your script, and thereby to get inside his.

When under pressure about electoral funding irregularities from various mainstream media sources, Reform UK leader Mr. Farage — a past-master invader of OODA loops, great and small — threw out a doozy: he did what no-one expected and resigned his constituency seat precipitating a by-election.

And then I thought: why should I be judged today or in the future by Sky News and their ilk? Why should they be the people that decide my fate when, as I repeat, I’ve done nothing wrong?

I’ve thought about it hard, and I’ve decided: today, I will resign as a Member of Parliament for Clacton-on-Sea, thereby forcing a by-election, which should happen, I hope, in short order.

Now, I’ve decided that the people of Clacton should be the judges of my actions. This will be a people-versus-the-establishment by-election. It’s a chance to stick two fingers up to the entire establishment. To frankly tell them where to go.

—Mr. Farage’s press statement announcing his resignation

Here Mr Farage explicitly shifts the terms, and subject, of the debate. He reframes it from an allegation that he, personally, has breached disclosure rules that apply to all politicians where, presumably, he assesses he has a low chance of success, to a question of unseen forces mobilising against this awkward representative of the people — this selfless teller of truths to power. The accused is re-rendered as victim.

But he is not alone: like Spartacus, Mr. Farage identifies with his electorate. He invests it with his own suffering. The way he tells it, it is the people of Clacton-on-Sea who are impugned by these allegations: he is merely their conduit. He makes his own embarrassment their struggle and their opportunity to stick it to the man.

Whatever you think of the substance, the form is clever. This is good oratory.

Shadowy establishment forces should not be judges in their own cause. Rather, the people should decide. Specifically this carefully chosen local constituency with whom Mr. Farage knows he is unusually popular.6

Mr. Farage has tried to re-render a dry procedural inquiry — albeit one with significant consequences — as a popularity contest. The rules do not allow the subject of allegations unilaterally to change the terms of inquiry, of course, so the investigation will continue — but Mr. Farage’s opponents will be at least temporarily disoriented by the turn of events. And he has repointed the public debate and bought himself some time to formulate further tactics to deflect from that dry central issue.

This is what, in an Argentinian footballer, we might recognise as “shithousery”. With the referee’s view impeded, having left his studs in on a tackle, Mr. Farage has gone down in a heap and is rolling around clutching his ankle, while his opponents protest too much, belatedly accusing him of foul play no-one noticed at the time.7

Not only has Mr. Farage chosen a most favourable audience to be judge in his cause — he has done so knowing how his main opponents are likely to react, and knowing that that will further play into his hands. His mainstream opponents are numerous — there are five of them — divided, disorganised, misaligned, and expected by constitutional convention to oppose each other as much as they oppose Mr. Farage. As long as they obey the rules, follow conventions and play to type, Mr. Farage knows he cannot lose this by-election.

Remember the distinction between “good” and “bad” here. Mr. Farage is the “bad” one. He is the wily old fox. Like an Argentine footballer, he has formidable conventional skills: he is as astute on the ball as any of his opponents. But unlike them, he is prepared to play at the fringes; dabble in the dark arts; push the limits of what he can get away with. Like Argentina, Mr. Farage presumes he has an edge — not through superior skill, but because he is the craziest guy in the room. His opponents won’t have the gumption to do the sorts of things he can do. It seems a safe bet: they never had the gumption before.

Count Binface and the last man (standing)

Novelty Candidate: We’re for the compulsory serving of asparagus at breakfast, free corsets for the under-5s and the abolition of slavery.

News Interviewer: I’m sure many moderate people would respect your stand on asparagus, but what about all this extremist nonsense about abolishing slavery?

Novelty Candidate: Oh, we just put that in for a joke! See you next year!

—Blackadder, Dish and Dishonesty

As these occasions tend to, this by-election has drawn a number of novelty candidates. Novelty election candidates are a venerable British tradition: some come and go; some almost become part of the, well, establishment. The Monster Raving Loony Party has haplessly—they might say “lucklessly”—contested elections for nearly half a century.

Another, active since 2017,8 is Oxford-educated satirist Jonathan Harvey, who plies his trade as “Count Binface” and, to the closest approximation, resembles Darth Vader, only with a plastic bin on his head. His policies include nationalising model railways and Adele — sensible policies for a happier Britain — and extremist nonsense like halting the sale of arms to repressive regimes.

In their way novelty candidates, too, are “Argentines”, only they tend not to be very good at football. They are a class of subversive political disruptors who thumb their noses at all electoral conventions, if not just for the sake of it, then in mute protest at the electoral system’s intrinsic absurdity and, perhaps, for the thrill of lurking behind a prime minister in an Elmo costume while he delivers a sober acceptance speech.

System incentives are such that, however meaningful their metaphysical point, novelty candidate “noise” is drowned out by the mainstream parties’ “signal”. They don’t register strongly enough on the political radar to attract any serious candidate’s attention, let alone get inside an OODA loop.

My enemy’s enemy is my friend

But this time, it may be different. For this time, Mr. Farage may have underestimated his opponents’ capacity to get inside his OODA loop. For all his popularity with one part of the electorate, another, larger, sector finds Mr. Farage positively objectionable.

To date, he has managed his unpopularity by dividing it into pieces comfortably smaller than his popularity and thereby conquering it, because each of those smaller pieces, once disconnected and put against each other, fight like ferrets in a sack.

But for all their quarrels elsewhere, a solitary issue does unite Labour, Conservatives, Liberal Democrats the Greens and even Reform breakaway party, Restore UK: that is their mutual opposition, personally, to Mr. Farage.

Usually that would not be nearly enough to unite them. But this is an odd scenario. But for the fact that it concerns Mr. Farage’s constituency, this is an inconsequential by-election. The Government’s sitting majority is such that there is less to be gained by any of the other parties from winning Mr. Farage’s seat — it wouldn’t change the voting dynamic in the House of Commons at all — than there is from Mr. Farage losing it.

When Mr. Farage won it in 2024, he captured 46% of the vote, representing a handsome majority over a bunch of scrapping ferrets. Taken together, those ferrets from other mainstream parties captured a small outright majority of the electoral votes cast, evenly distributed between them. If they could buck convention, and swallow some pride, the ferrets could deliver Mr. Farage a bloody nose, without needing to gain any more net votes.

But how to persuade scrapping ferrets to unite against a common enemy? However appealing in theory, it will be a cold day in hell before a diehard Labour voters cast a ballots for a Tory, and vice versa — that is what “diehard” means — so the prospect of all the mainstream parties miraculously agreeing on, and then persuading their constituents to vote for, a single “unity candidate” amongst them seems rather beyond the pale.

Unless the unity candidate represented no threat to any of them. The ideal fellow would have meaningless policies, or none at all, beyond uncontroversial stuff like nationalising Adele.

Enter Count Binface, who quickly spotted this opportunity and presented himself as that unity candidate. In a rare example of political sophistication, the mainstream parties all cottoned on to the opportunity and stood their candidates — if not their party machinery — down. There will be no Conservative, Labour, Liberal Democrat, Green or Restore9 candidates taking on Reform UK in the Clacton-on-Sea by-election 2026.

Mr. Farage will contest his seat with one “realistic” opponent: a man with a bin on his head.10

Mr. Farage’s reaction — to complain — has been heavily ironic: in not playing by rules that Mr. Farage has subverted, the rest of the system is running scared.

“If they believe in the democratic process they put up candidates, but they won’t do it because they’re scared of the result, and they know that I’d beat them.”

In fact, in standing down, the mainstream parties are respecting Mr. Farage’s wish that “the people of Clacton should be the judges of my actions” without the distraction of policy, the economy, or the government’s track record since the last election. They are saying,

“Let this be entirely about you, and your constituency’s opinion about you. In having no policies and not representing a mainstream organisation, the single substantive candidate running against you is, effectively, a no-confidence vote.11 This way, the question becomes: Does the electorate have continuing confidence in Mr. Farage or not?”

Nevertheless, political pollsters and pundits say Mr. Farage is likely to win the by-election. But, by vanquishing only a man with a plastic bin on his head, Mr. Farage is deprived of his moral victory. His opponents have outdone him at his own game. By playing at the margins of convention, by acting contrary to type, by defying predictions — by eschewing their usual elegant, rational, clear, sideways-passing football and thereby disrupting Mr. Farage’s own destabilising game, the mainstream parties may learn a lesson here. There is a place for shithousery in the beautiful game.

What this means for England

JC’s posse never tires of reminding him he knows nothing about football and so should shut up about it, but perhaps there is a lesson for England’s footballers too: to embrace the dark arts, and get inside their opposition’s OODA loop.

England has an ill-starred history of being on the wrong end of shithousery: Diego Maradona’s Hand of God in 1986, Diego Simeone’s theatrical collapse on David Beckham in 1998; Cristiano Ronaldo winkishly engineering Wayne Rooney’s dismissal in 2006, Italy’s all round cynicism to prevail in the 2021 Euros.

At some point, England must learn its lesson: if you can’t beat ’em, join ’em.

Wither voice recognition?

I’m trying something new for this post, and that is using the Wispr Flow voice recognition application for dictating rather than writing.

This does the useful but unglamorous job of voice recognition (a technology that is well developed) and overlaying some AI pattern matching to fix up and properly punctuate dictation. JC’s nasal mumbling comes out looking more presentable.

For those who never learned to touch type or who regularly input significant data on a mobile device, voice recognition should be a real productivity opportunity.

It is odd it has not caught on more quickly to date.

Using AI to overcome some of the obvious limitations of dictation (that includes making errors, ums, ahs, and contradicting yourself: that is to say, applying a small amount of limited editorial control) is an ideal application for AI. It saves a good deal of incremental time. It is obviously testable and correctable at the time, so little or no risk of hallucination.

Wispr Flow works pretty well. You can train it to correct my annoying verbal and linguistic tics. As do all lawyers, I tend to overcomplicate my sentences. It would be great to train AI Assistant to take my turgid rambling output and rectify it by reference to specific rules I specify.

For example, “convert all nominalisations into direct verbal constructions”. “Replace all weak verbs with strong ones and avoid equivocal language like I think that — and this seems to be —”. These features help me eliminate awkward aspects of my natural speech.

Getting the rules just right is important, but you can overdo it. Sometimes the output is nothing like what I said and feels generic and “sloppy”.

It includes a handy feature: you can select your output text, and it will polish it according to your preferred rules. This will directly challenge Grammarly and other spell‑checking applications.

All this does prompt the question: why isn’t voice recognition more prevalent? Accurate voice recognition is hardly new. Maybe these tools will send it over the top.

But the ongoing deprecation of office workspaces has something to do with it too.

After all, forty years ago, voice recognition was the norm. We didn’t call it that: we called it “dictation”. We didn’t use tech—beyond cassette recorders. The intelligence was real: a human typist.

In hindsight, having one employee dictating and another typing, and the inevitable iterative process between them to finalise a document, looks highly labour-intensive.

Collapsing that down to a single employee composing and typing was less so—once the office manager [for younger readers, that’s the chief operating officer—Ed] got over the idea that “we don’t pay lawyers to type”.

But dictating without having to type is surely quickest of all. So where is it? Why isn’t Wispr Flow eating the world?

One factor may be the concurrent changes in the physical workplace that came with new technology: dedicated offices gave way to shared offices, then cubicles, then open‑plan spaces, and finally hot‑desking.

Over that time we became quieter and more timid. Noise is distracting, though on a busy trading floor it is a fairly pleasant, comforting hubbub. Speaking aloud can feel slightly embarrassing.

At the same time, dictation — indeed, all oral communication — has deprecated sharply. Desk phones have disappeared, replaced by Teams and Zoom. Phone calls — once ad-hoc, bilateral, analogue affairs — have given way to prearranged online meetings. Calling someone out of the blue, without arranging it in advance, is now the height of rudeness.

This, incidentally, is one advantage—probably the only advantage, beyond the saved ground rental—of our post-COVID generational shift towards remote working: suddenly we all have our private spaces back, and voice recognition is a realistic prospect.

Local and distant networks

The above touches on the crux of the digital divide: since digital networks arrived in our working lives — the world-wide web broke its academic borders in the early 90s — the nature of our networks has changed.

Networks in the pre-digital era

The pre-digital era was based upon small, rich, accretive local networks. These networks were multilateral: they involved people interacting, in person, in the workplace, or in physical meetings. The longer such a network lasted the better it got, as relationships formed, ways of working evolved and “institutional capital” accumulated. Hence these were rich, accumulative networks.

They were augmented by a thin layer of what I will call remote networks, which only got used were the local ones weren’t suitable. These these could be electronic — phone, fax, telex or telephone — or physical — snail mail or courier — but in any case were mainly bilateral in nature, and didn’t have the quite same “capital accumulating” nature.

Building relationships was central to business in the pre-digital era.

Local networks in the pre-digital era

Local physical networks had distinct advantages over remote ones. They were immediate and multilateral — people who were on hand could convene quickly —the communications were rich — not just “text” but “speech”: imbued with relationships, institutional knowledge, body language and context — multilateral — as many people as you needed could attend — and instant — but at the same time informal: dialogue was not systematically captured, logged, audited, or recorded, allowing candour, correction and the safe removal of faux pas, irrelevance and error before creating any formal minute or record of the meeting — and free — in the sense that there was no incremental internal cost to having already-engaged employees meet together. (Employee cost attribution even today is minimal; in 1990 it was non-existent) since the employees were already on the payroll.

Only where a physical meeting was not possible, would you opt for a remote communication. These were comparatively poor — usually bilateral, and at best (phone communication) conveying a fraction of the information of an in-person meeting; telex and fax even less so — or significantly delayed — telex and fax might take hours, mail correspondence days — and in any case incrementally expensive. Telephone and fax costs, postage and courier were meaningful costs per communication. Unlike labour costs, these were not baked in, and could be specifically accounted for.

Therefore before the world wide web every business — rightly — would prefer the local rich, free networks available to it — over remote, poor, expensive bilateral networks.

We organised ourselves accordingly. Firms organised into offices and branches, where people with a need to quickly interact could do so. Offices organised into compact districts where one could easily meet customers, counterparties, advisors and competitors. We built complex, rich, local, interlocking networks. We built relationships, reputations and trust. Much of the strength of the network was implicit — the shared history, knowledge, and common interests.

By contrast, it was hard to build reputation and trust over a telephone line, and impossible by fax.

So, these were the critical features of a local network: immediacy, speed, convencience, informality, memory, trust, and subtlety. These features are hard — impossible, really — to quantify.

But before 1990, not everything in business needed to be quantified. There was a costs to doing business, and that was that. The wealth of local networks is “illegible”. You can’t see it in the financial accounts. It may was well not be there.

That doesn’t mean it isn’t there, however. So:

Local, physical, rich, fast, cheap, invisible networks good.

Remote, electronic, impoverished, slow, expensive, visible networks: bad.

Networks in the post digital era

When the World Wide Web burst onto the public consciousness in around 1993 — I remember attending a seminar about it — everything changed, but nothing did.

Local networks didn’t change at all.

Everything changed about remote ones.

Digital, not analogue

Remote networks became now digital, not analogue. Whereas analogue communications occupied physical space and took time, and where they could be copied at all, quickly lost fidelity, digital communications occupied no space, could be copied, recorded or moved over any distance instantly and at zero marginal cost.

Whereas analogue communications had to be embedded in a “substrate” — paper, mainly — digital data needs no substrate. It travels unaccompanied.

Infinite audit

While digital solved the problem of incremental cost and created an “opportunity”: infinite audit.

As we will see, where there is “infinite audit” you no longer need “trust”: you have all the receipts.

But trust turns out to be quite important. Everything, always, being on the record has a chilling effect on candid communication. Things you might once have said are no longer said. This can be a boon and a bane.

There is one fork of the information revolution still cantering towards a fully trustless network: crypto.

High bandwidth

As the physical network has built out and chips have grown faster, bandwidth has exploded. In 1990 it took ten minutes over a 56k dial-up modem to download a day’s worth of email. In 2026 we can stream virtual reality to a mobile device in the scottish highlands.

Multilateral

In a distributed digital network, everyone is online — connected, and able to send and receive — all the time. Because communications are instant, costless and copied with no loss of fidelity, digital remote networks can be multilateral: we can quickly convene an all-hands video conference.

Before the internet, remote networks — phones, faxes and letters — were a poor relation.They were expensive, slow, of poor quality, and cussedly bilateral.

Now the remote networks are fantastic. They are fully audited, instantaneous, high-bandwidth, free and multilateral.

Not only do they outperform the analog remote networks in every possible regard, they seem also to outperform the rich local networks.

COVID as a live-fire experiment

For the longest time, Chief Operating Officers around the world [for older readers, that’s the office manager—Ed] wondered about the stubborn cost of maintaining an office in the CBD. They had systematically rolled back employee benefits — “bring your own device” is one thing: but even for McKinsey, “bring your own premises” seemed a step too far.

Then came COVID, and we were all bounced into trying it whether we liked it or not. That live fire experiment ended more than 4 years ago, but things have not yet gone back to normal.

There is an odd confluence: this suits many employees — especially us older ones, who quite like working out of the box room — and it rather suits the office managers, as it gives scope for downsizing premises — but you might wonder whether it rather misses the point about what is so good about rich local networks.

I might return to the question of rich local networks and poor distant networks. All complex systems finds their own configuration, and if we participants don’t like where it ends up, all we can do is change our own behavior and see if that corrects it.

If we prefer distant networks over local ones in our daily activities; if we accept the premise that cost, convenience, and auditability outweigh the value of slowly built relationships, trust, and wisdom, we should not to complain when the system treats us poorly.

Wispr Flow redux

Just wrapping up with Wispr Flow. Interestingly, the longer I wrote this newsletter, the less I relied on Wispr Flow, though I’m back to using it now for this closing section. I’m not sure whether this reflects a preference for typing or simply familiarity.

Wispr Flow has a neat “polishing” function it does not depend on voice recognition. You can apply it to any text you’re editing, and you can also create your own rules and AI prompts for it.

For example, I was exasperated at first that Wispr Flow did not handle “smart” punctuation (curly quotes and so on): I am a bit anal retentive about curly quotes, en-dashes and thing like that — but you can set a polishing prompt to convert everything to them.

It strikes me this is how we should be using AI: not to replace human effort in toto, but rather to take away the boring faff of interacting online every day — getting typing and punctuation right.

Now is the worrying time—
Woe! Woe!
Behold!
Armageddon and the four horsemen of the apocalypse:
Famine, Pestilence, Death—
And the other one.

…

Sometimes, you know, God can be so unimaginative.

The Young Ones, Interesting (1982)

There has recently been a bit of conflab amongst those challenging Lucy Letby’s convictions about the motivations of the “gang of four”: did the COCH paediatricians really believe she was harming babies?

Opinion is split. A hard core is convinced the consultants had ulterior motives from an early stage. The more liberal fringes feel it is a bit more complicated.

Some think it is beside the point. I’m in that camp.

Exchanges have been testy. Even petulant. This is no doubt disappointing for those who value civil debate and want to keep the innocence campaign on the same hymn sheet, but fun for those of us who find a bit of verbal argy-bargy bracing. And it tends to rebut the idea there is some vast Letbyist conspiracy so, I’m all for it.

The point at issue is how to think about the behaviour of Ms. Letby’s principle accusers — the so-called “gang of four” CoCH consultants.1 Were they misguided or malicious?

This not worth even talking about unless it transpires she was not guilty so — apologies in advance to my many pitchforker readers — we will, for a moment, take it as a given that Ms. Letby did not deliberately harm any infants.

It’s complicated

There is a continuum of possible “blame points”. At one end, the consultants2 were dispassionate and logical at all times but nevertheless somehow reached the wrong conclusion, and the system then swamped them. At the other, from the outset they conspired in a cynical attempt to have Ms. Letby imprisoned knowing full well she did nothing wrong.

There are, naturally, a host of positions in between. As one poster put it, “it’s complicated”. This debate has an odd resonance with the public debate about Ms. Letby herself. Both extremes are highly improbable. They leave untouched a wide range of more probable, but less satisfactory explanations. We like our narratives to explain the world to us. We do not find useful ones that say, “Well, we just don’t know”. We prefer conclusions, however unlikely they may be.3

The situation of risk was an “unexpected cluster of medical collapses and deaths in the CoCH neonatal unit”. Since the unit is there to prevent negative health outcomes, on its face it has failed. You would expect senior professionals in that unit to be concerned, and to look for causes for its failure. An obvious one is intentional human agency.

Another is unintended human failure. That may implicate the consultants themselves. Being human, they were subconsciously motivated to prefer an explanations that served their interests as well as the hospital’s.

In looking for explanations, the consultants were inherently conflicted. “An undetected serial killer nurse attacked these children” was a better explanation than “these children collapsed as a result of shortcomings in the care we were responsible for providing” because it laid the blame at someone else’s door. Especially once they had identified and escalated their concerns to management.

But this does not mean they were malicious. All humans act self-interestedly all the time. It is our default operating mode. We cannot attribute malice without a lot more information — information we are, at this remove, highly unlikely to get.

It doesn’t matter

But in any case, it doesn’t matter.

What matters is that the consultants were wrong — again, assuming they were wrong — not why. If the goal is to overturn the miscarriage of justice, focusing on how blameworthy the consultants were is a distraction.

For if, in forming their honest opinions that Ms. Letby was responsible, the consultants acted with clear-eyed surgical precision and the equanimity of modern saints, yet were still demonstrably wrong, Ms. Letby would be no less deserving of acquittal. If they acted as a scheming cabal she would be no more deserving. Focusing on the consultants’ motives is to make a category error. It is not the consultant’s motives and actions that determine whether Ms. Letby should be in prison, but her own.

What difference does it make how malicious the consultants were? Isn’t there a ball that needs to be played here? What does it achieve to take out the man?

It’s a nice explanation

To be sure, “wanton malice by consultants” is a convenient, easy, satisfying explanation. It offers a clean, resolved, retributional answer. There is a heroine, some villains, a smoke-filled room, an early setback and a great final conflict vouchsafing apocalyptic justice. It cleaves nicely to the monomyth archetype.

It sees Ms. Letby’s ordeal as discrete: a one-off, freak occurrence that no-one saw coming but that we have nobly resolved, restoring order to the universe. It appeals to the would-be hero, riding in on a charger, saving the damsel clearing out some some bad apples and returning home in triumph. The world is left in situ: everything, and everyone else can remain in place doing exactly what they were doing. This is justice as a surgical strike.

Everyone else in the system gets a pass. For, if this really was a wantonly malicious action — if the system is otherwise ship-shape and coming up to brief — it should not happen again, and should not have happened before.

But it’s a bad explanation

But since we know it has happened before, and since,4 “wanton malice” is also a bad explanation. The “healthcare serial murder” pattern, whereby nurses are convicted of retrospectively constructed crimes on next to no direct evidence over their insistent denials, keeps recurring.

If it keeps recurring and wanton malice is the cause, then the system is vulnerable to wanton malice, and needs to be fixed. Rooting out bad apples is, at best, a game of whack-a-mole. They will keep popping up as long as the system is configured to produce them.

But it isn’t likely to be wanton malice, for two reasons: firstly, the criminal justice system is pretty good at identifying vexatious complainants and disingenuous witnesses and excluding their evidence.

Secondly, the healthcare system is pretty good at screening out vexatious people so you don’t get truly malicious complaints in the first place. Taking these in reverse order:

The medical profession is comprehensively regulated and governed. Its practitioners are systematically enculturated, trained and credentialed to eliminate wantonly malicious people. Over the 15 or so years it takes to qualify as a doctor in the UK, candidates are exhaustively vetted for fitness to practice.5 The profession weeds bad apples out.

For the same reason, even compared against the already low rate of murderousness in the general British population, we should not expect many nurses to be murderers. That incidence would be far lower still.6

rNo system is perfect, and it might not catch all malicious professionals — it is, of course, not impossible that a senior medical professional would wilfully railroad an innocent nurse to prison7 — but the incidence of that kind of behaviour should be extremely low. We should not expect to find four malicious professionals colluding in the same hospital.

If we do, then the problem is predominantly with the system, not the bad apples.

The Cheshire Triangle

But the “healthcare serial murder” pattern repeats, almost identically, all over the world — Brazil, France, America, the Netherlands, Italy, and in the UK. It happens a lot in the UK.

It happens, in fact, in a small patch of the English heartlands I call the “Cheshire Triangle” where there have been nine alleged cases in quarter of a century, including Beverley Allitt (1991), Anne Booth-Grigg (2002), Colin Norris (2002) Barbara Salisbury (2002), Ben Geen (2003), Rebecca Leighton (2011), Victorino Chua (2011) and of course Ms. Letby. The geographical and temporal clustering is striking, as is the modus operandi: seven of the nine involve allegations of insulin poisoning.8

The Cheshire Triangle — yes, it is a terrible name: you are welcome to suggest alternatives9 — is unusual not just for its spatial and temporal sequence. The juridical strike rate is also uncommonly low. Of the nine cases, one has been overturned, two were dropped before trial, one resulted in no murder convictions, and four are the subject of active, ongoing challenge.

If there really are vindictive hospital administrators, then there are a lot of them in a small area.

If there really are nurse healthcare serial murderers, there are a lot of them in a small area too.

Maybe it isn’t the apples

All this points away from bad apples. For either:

1. There have been many serial murderer nurses in and around Cheshire, who were all correctly identified by their colleagues.

2. There are many malicious hospital consultants in and around Cheshire, who have each railroaded innocent nurses to prison.

3. There is some odd combination of the above, where some were genuine nurse serial murderers but others were malicious vilifications of known innocents.

4. Or something else is going on: there is, instead, some kind of latent system error — a recurring failure mode in how doctors, hospital managers, police, lawyers and courts interact with unusual clusters of medical misfortune. In this case, perhaps cognitive biases, institutional and financial priorities and conflicting personal incentives — and not outright malice — are at work.

Unless there is compelling direct evidence to corroborate them, scenarios 1 and 2 are equally unlikely, and scenario 3 is even less likely: the first two each require one rare event (genuine murderers or malicious consultants) and the third requires both.

From everything we know about how complex organisations operate, how the people in them behave, and how prone the combination is to failure, scenario 4 is totally plausible. It is, in essence the “Post Office Horizon” scenario.10

It looks bad: it looks like systematic malice up and down the county — take your pick by whom — but it is nothing of the kind.

Translating that last scenario to the Countess of Chester: these are not serial murderer nurses or malicious consultants, but a strange combination of circumstances, events and interacting social structures that creates scenarios that lead the consultants to mischaracterise an innocent nurse as as a murderer, and this intersects a latent vulnerability in the criminal justice system, such that these cases are not seen for what they really are.

This happens. We know it happens.

This is not to say that the consultants — or for that matter the implicated nurses— are entirely without sin, or above stern criticism, but they are not the root cause of the problem. They are, in a way, its symptom. Something else is driving this. If the system were working properly it would intervene on time: it would identify the sins and failings of nurses and consultants and stop them: they would get the censure they deserved at the time, not years later, after rectification of a terrible injustice.

This is a far more plausible explanation. It does not satisfy the wish for a quick clean resolution. It does not satiate the bloodlust for retribution. It points instead to hard yards: this is a far less tractable problem.

The goal should be to fix the system, not defenestrate bad apples. Even if they are bad apples, the system tolerated them. Rid the system of its defects. Make it immune to malicious doctors — and for that matter serial killer nurses! On either account, the system has repeatedly failed.

Why the system failure points away from malice

The UK’s criminal justice system has, of late, had its moments, but on the whole, its remarkable achievement over centuries has been to evolve techniques to counteract malice. It is good at isolating liars and rooting them out.

This is another reason these doctors were not probably not outright malicious: if they were, the justice system would have found them out. Its weakness here may be exactly that they weren’t outright malicious: they were, instead, accepted as experts expressing sincerely-held views. The system has a weak spot with expert evidence. Again, this is not a secret: the Law Commission has been warning about it for years.11 Experts who are simply mistaken are harder for non-experts to gainsay. They are resistant to cross-examination. They are harder to falsify.

Of course, sincerely-held views can become more tendentious as contradicting information emerges. But once we commit to a position, we are motivated to cling to it long after it is tenable. We should expect buried conflicts of interest, methodological errors, cognitive biases and so on—the ordinary artefacts of imperfect humans interacting imperfectly, in other words—to cause this sort of thing.

Attributing malice—or, for that matter, even blame—is to be distracted from the far important issue of understanding the interlocking system effects that cause these outcomes and fixing them.

It is surely better to reorganise the system to stop these miscarriages happening—isolating root causes of the clusters themselves—rather than embarking on a witch-hunt against (perhaps) below-average doctors. The system should be designed to cope with ill-advised acts from below-average doctors, because literally half of all doctors are below average.

There’s another reason to prefer the systems explanation over malfeasance: that way you create a route by which incumbents can, without personal prejudice, accept there is a problem and work to fix it.

If you back accusers into a corner they are bound to be defensive. Attributing blame is to take sides and entrench positions, rather than to diagnose the problem and resolve it. In other words, if you really want to fix a problem, as a first step, don’t blame people who may be, in their own way, as much victims of the system as anyone else. Sure: the consultants may not be in prison, but if Ms. Letby is exonerated their reputations are unlikely to recover. Their errors were, at first, understandable: this happens a lot, after all. If the system worked to catch and remediate an early error, rather than entrenching it, the consultants would not be in the place they are now in.

Fix the problem.

By now I hope the netting problem is clear: regulations require each dealer to obtain lengthy legal opinions for every master agreement in its portfolio. A full service broker dealer may have hundreds of thousands, across scores of jurisdictions. Swap, stock lending, repo, and prime services master agreements each have different closeout mechanisms. Each requires its own legal opinion.

Across those jurisdictions there are, literally, thousands of legal entity types, the netting requirements for each of which will, subtly, differ.1

Those entity types may have similarities across borders — there are corporations, partnerships and trust-like things in many jurisdictions, and they fulfil similar functions — but they are by no means standardised. There are private corporations, public corporations, joint stock corporations and special purpose vehicles. There are protected cell companies and segregated cell companies. There are unlimited partnerships, limited partnerships and limited liability partnerships. Trusts, foundations, stichtings and fiduciaries. Some have legal personality, some don’t. And the rules and resolution protocols for even simple corporate entities will differ between jurisdictions. An Austrian GmbH is not subject to the same rules as a German one.

Close-out mechanisms in standard agreements like the ISDA are designed, as far as possible, to work universally, but this is an imperfect science. In some jurisdictions automatic early termination ensures netting works, in others it invalidates the agreement altogether. Additional clauses covering local peculiarities may be needed.

There is a bit of regulatory conflict here. This is blue-on-blue action. By and large these local regulations, and their peculiarities, were originally designed to promote fairness between all a bankrupt’s creditors, rather than to vouchsafing a given dealer’s capital framework. You would think that all jurisdictions would want to ensure maximum capital efficiency to give local businesses optimal access for international capital markets. But that is not how the regulations are necessarily framed. That said, should there ever be latent conflict between insolvency and capital rules, local regulators are strongly incentivised to fix them pronto. The consequence of not doing so is to shut themselves out of international capital markets. That is a bit like sanctioning yourself. So, we saw in 2016, when a German court decision threatened to undermine the effectiveness of close-out netting, the German government quickly intervened to change the law.

Hence the need for constantly-updated netting opinions. However long and however erudite, a netting opinion must, for each of the hundreds of thousands master agreements in the firm’s contract portfolio must be boiled down to a single question:

Will close out netting work, yes or no?

That determination will set a “netting flag” in the firm’s risk systems for each agreement. That, in turn, will determine how much capital the bank must hold against that exposure under that agreement.

Long, windy academic tracts2 about aleatory contracts and the anti-deprivation rule established in Whitmore v Mason (1861) 2 J&H 204 are not well suited to answering that simple question.

There is thus a collision between the airy, theoretical world of regulation and a dealer’s greasy operational reality. It has to answer “yes” or “no” — realistically, “yes”—the consequence of “no” is almost always “we cannot trade with this entity” for every contract it enters into.

Yes, opinions are required to be “written and reasoned”. But they should also be practical.

Mechanically, setting netting flags involves three interacting “systems” inside a dealer’s greasy operational reality: its risk engine, its agreement database, and the diffuse activity of gathering, reviewing and approving netting opinions. These three systems are quite different.

The risk system has to work.

The agreement database has to feed the risk system.

Netting opinion review is a manual, offline human activity that no-one wants to do because it is so boring.

Risk engine

Firstly, the risk engine: this will almost certainly be a industrial-grade computer system. It must be, and will be, built like a tank. It ingests trade data and market valuations for every transaction and every collateral position, aggregates them and matches each to a single master agreement record. From this it calculates the following day’s margin calls, manages risk limits and credit headroom for the client and the capital consumption for the agreement in question.

This exercise is fiddly enough: for those calculations to be possible, each swap needs to map to a single ISDA, each stock loan to a GMSLA, each repo to a GMRA and so on. Should the same counterparty have two ISDAs or side-by-side collateral arrangements—unusual, but not impossible—the risk engine’s logic needs to map swap trades and their exposures to different ISDAs and CSAs. Failing to get this right can be an existential risk, so this system should be bulletproof.

Master agreement database

Second, the Master agreement database: this is where all master agreements go once negotiations have concluded and the agreement is executed. Key terms of master agreements and collateral arrangements will be recorded in the master agreement database.3 This will have a solid functional core—it provides necessary master agreement data to the risk engine—but the system it is built on is quite likely to be old, heavily patched and a lot of its data, especially relating to older agreements, will be quite ropey.

At the dawn of the age of swaps, there was little formality around the negotiation of master agreements. That has changed over forty years in response to the manifest crises and shocks of history, but the content of these systems will still be uneven. What once was a bespoke negotiation handled by learned counsel and magic circle law firms has long since been industrialised: modern contract negotiation is outsourced, offshored, juniorised and heavily constrained by policy and approval workflows which provide the negotiation data record for each master agreement.

However, contract documentation is far from standardised. There is no good reason for that these days: it is a commoditised product, and the terms and exigencies of a master agreement are well understood and boil down to a handful of simple credit points, but master agreement negotiation remains a cottage industry that keeps a lot of busyworkers gainfully employed.

If I had to guess I would say AI will not change this.

In any case, the master agreement database inevitably contains less data than is embedded in the master agreements themselves, after all that earnest pettifoggery, and on occasion misrepresents it.

In any case, part of an agreement’s data record—specifically the “netting flag”—must somehow get from the agreement database to the risk engine. But first it needs to get to the agreement database, and this is where the netting opinion review process comes in.

Netting opinion review process

The last of those three systems is the netting opinion review process. To populate a netting flag in the agreement database, one must know what the relevant netting opinion says. This is handled by what we will call the “netting opinion system”. This implies something grander the loosely-governed, resented, syndicated human activity it is likely to be.

The netting opinion system will be a disparate collection of typed forms and spreadsheets stored on a folder in a Y: drive somewhere, or an underspecified SharePoint site or access database built in 1994 and now maintained, reluctantly, by a team in Gdansk. It may include a shared inbox, a subscription to online reporting services or an arrangement with a local law firm to provide summaries.

This process is a monster. Some poor sod in the legal department will have to syndicate the job out amongst the bank’s derivatives lawyers, who between them must review, construe and approve the netting opinions. That poor sod, in one institution, once upon a time, was me, readers.

You can call that role something high-faluting, like “netting opinion compliance lead” but it is a thankless task.

You must assign each jurisdiction that your firm trades against to a fellow lawyer: usually, each one gets three of four each. They will not thank you for it. They then must keep their allotted jurisdictions, and all the opinions for them, up-to-date.

They must check with credit what risks the firm has on, against what kinds of counterparties, under what agreements in that jurisdiction. They must compare that against the industry opinions – there will likely be several, which will not necessarily be consistent — to ensure everything is covered. Where there are gaps—usually, there will be—they must commission bilateral opinions to fill them.

They must populate “netting review sheets” explaining clearly which counterparties are covered, what products are in scope and what departures are required from the legal standard to ensure close-out will work as intended. Once these are approved—there is of course a governance process—these must be then filed somewhere the negotiation team can find them: they will need them to set netting flags when onboarding and negotiating with new customers. This is all laborious, time consuming, hard to effectively govern or supervise, and expensive.

Regular subscribers leave us now — but next time we will pick up by looking at a solution. Premium subscribers come along as we look at:

Industry opinions

How industry opinions work, and form the core of the netting effort

Burning down the house

How, sometimes, starting again is not the worst idea

There must be a better way

What if, what if, what if… What if someone built this?

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Little Swap-a-Thing

Mama said, “Now, Eggfried dear:
I must go out and leave you here.
But mind now, Eggie, what I say:
Don’t swap your things while I’m away.
The fearsome cherry-picker swings
For little boys who swap their things.
And ’ere they dream what he’s about
He’ll take his great big plucker out
And swipe their cherries clean away
No matter what they do or say.”

As soon as Mama turned her back
Young Eggfried swapped. Alack! Alack!
He paid away a floating rate, and
In came cherries, by the plate!
But scarcely could he take a bite
When who should give the lad a fright?
The door flew open, in there ran
The great long-fingered cherry-man!
Oh! children, see! The plucker’s here!
He’s grabbed our little Swappie’s ear!

Pluck! Swipe! Snatch! The Plucker goes.
Eggfried cries, “Oh, no! No! No!”
Pluck! Swipe! Snatch! They go so quick!
Every single cherry picked!
There’s nothing left in Eggfried’s bowl
To fill the chasm of his soul.
Then Mama’s home; poor Eggfried stands,
His hanging head! His empty hands!
“See?” says Mama, “The woe he brings
To naughty little Swap-a-Thing!”

—Otto Büchstein, Little Swap-a-Thing, from Cruwwelpeter, (1874)

History proceeds one disaster at a time and regulatory capital is no exception. It was forged out of existential crisis.

Today, we go back in history and look at the existential crisis from which the requirements of modern capital regulation flowed: a small and apparently inconsequential skirmish in the death throes of the battle of Bretton Woods that rather got out of hand. It involves, as these things tend to, a small town in Germany.

A long time ago in a small town in Germany

Bankhaus Herstatt was a Cologne small private bank. Following the collapse of the Bretton Woods system in August 1971,^[1] Herstatt had made a series of massive bets that the U.S. dollar, which had been hammered by speculators, would recover. It didn’t. By 1974, most European currencies were freely floating and Bankhaus Herstatt was nursing losses ten times the size of its capital base. This could not carry on indefinitely, and didn’t.

Late one afternoon in June, regulators arrived at Herstatt’s headquarters while it was settling the day’s FX transactions and shut the bank down. All hell broke loose. It is fair to say regulators were not expecting this.

Under its FX positions Herstatt was paying away U.S. dollars and receiving deutschmarks.^[2] Being late in the afternoon, its European counterparties had already settled their deutschmarks, but by the time the regulators arrived it was still early in the New York morning and Herstatt’s U.S. dollar correspondent banks^[3] had not yet released their payments. When they found out about of Herstatt’s failure, they cancelled them. Herstatt never satisfied its dollar obligations, leaving its European counterparties out of pocket.

Sorting this ought to have been straightforward: return the deutschmarks, close out hedges and the counterparties could settle, or prove in and solvency, for the difference in value. But Herstatt’s liquidators didn’t see it that way. They refused to return the deutschmarks.

German insolvency law allowed them to treat the deutschmarks as having settled. They were therefore an asset in Herstatt’s bankruptcy estate. Its dollar obligations hadn’t settled. They were a pending liability. Since they could not legally be set off against the incoming payments. The liquidators kept them. They “cherry-picked” the deutschmarks.

Cue utter mayhem as the global currency markets froze, and banks refused to make any payments where they weren’t totally sure their counterparties were able to pay. This failure to remit currencies meant banks couldn’t satisfy their debts in those currencies, prompting a chain reaction that nearly brought down the international banking system: banks stopped trusting each other to complete transactions across different time zones.

The system was tightly coupled then: what with the advent of computerisation, it is even more tightly coupled now. Regulators around the world decided they needed to do something.

What they did was to form the Basel Committee on Banking Supervision. It has no direct power to make law, but its members do, in their individual jurisdictions. The committee’s work — the Basel Accords — are enshrined in prudential regulation around the world.

Things were sorted out, after a fashion, and the situation returned to normal. Herstatt might have been a crisis averted, but as the information revolution gathered pace and the financial system increased its rate of stroke — and as new fangled financial instruments like swaps emerged blinking into the light promising, alongside precise risk allocation the outside chance of utter financial destruction, the Basel Committee’s rank-and-file membership began to worry. That old fairy story about Little Swap-a-Thing haunted them. Weren’t these new-fangled “swap” instruments just like that?

Yet swap dealers were not obliged to hold capital against their positions as ordinary lenders were: there was no loan of principal under a swap. Without capital charges, dealer derivatives books were quickly growing.^[4] Regulators feared credit risks might be accumulating out of sight and “off balance sheet” where they would not be protected by bank capital ratios should there be another Herstatt-style disaster.

The 1988 Basel Accord required swap dealers to hold capital against their gross “in-the-money” swap values. Not the whole “notional” amount of the swap: only its mark-to-market exposure — its replacement cost, essentially — if owed to the dealer. That was an unsecured debt claim. Amounts the dealers owed to their counterparties under other transactions could not be used to offset the dealer’s claims.

The new rules treated dealer swap exposures as if insolvency cherry-picking was a certainty: dealers could not offset their out-of-the-money positions. This dramatically choked the demand for swaps.

But where regulators saw horror, dealers saw opportunity lost. The new asset class offered fluid risk management that, they felt, should not be buried by punitive rules. The dealers, through their industry association ISDA, set about fixing the problem. They overhauled the half-hearted close-out provisions of the 1987 ISDA Interest Rate and Currency Exchange Agreement, which the regulators felt was vulnerable to cherry-picking, and in 1992 published an updated version. It had much more robust netting provisions.

The regulators weren’t immediately persuaded, but by 1995 they had come round to the idea. They would recognise “netting” under this contract, but on a couple of conditions.^[5]

Firstly, the dealers must have in place a suitable netting contract:

...which creates a single legal obligation, covering all included transactions, such that, in the event of a counterparty’s failure to perform due to default, bankruptcy or liquidation, the bank would have a claim or obligation, respectively, to receive or pay only the net value of the sum of unrealised gains and losses on included transactions...

The 1992 ISDA ticked that box.

Secondly, dealers must obtain, under all relevant laws — their own, the counterparty’s and those governing the netting contracts:

... written and reasoned legal opinions that, in the event of a legal challenge, the relevant courts and administrative authorities would find the bank’s exposure to be such a net amount

And so was born the regulatory requirement for lengthy, verbose netting opinions: you must have confirmation from qualified legal advisor in the relevant jurisdiction, in detail, that, even if it wanted to, a bankruptcy official could not cherry pick in-the-money transactions. You needed opinions for each contract type, each counterparty type, and each relevant jurisdiction. That is a lot of jurisdictions: the insolvency rules relating to a a société anonyme in Belgium are different from those relating to a société anonyme in France. ^[6] A decent-sized bank might trade, variously, in 90 jurisdictions, against dozens of different legal entity types in each, and under six or seven different master netting agreement types.

That is a lot of opinions.

Shoulda coulda woulda

Now, a couple of things to say about those netting opinions. Firstly, they must be to a standard of certainty known in the trade as “would-level”. This is pretty definitive: “beyond reasonable doubt” and not “balance of probabilities” territory. It won’t do to say that netting should be enforceable, or is likely to work. The opinion must be as categorical as one can be about a hypothetical situation: the agreement would, not should, be enforceable.

In a part of the law as strewn with discretions, equity, best efforts, little old ladies and Welsh hoteliers as is bankruptcy, getting a “would-level” opinion is a hard threshold to cross. Just saying, “well, once a company is in formal bankruptcy an official receiver has a wide general discretion to enforce or repudiate open contracts — to “cherry-pick” — in the best interests of the company’s unsecured creditors” has the potential to blow a netting agreement out of the water. The “single agreement” has some defences against that, as we will see, but still: simple, apparently reasonable, discretions, put there by national regulators to make sure bankruptcies are orderly and everyone gets a fair shake, are potentially problematic. This is a “blue on blue” problem: one set of domestic regulations make life harder under another set of universal regulations, even though both are targeting the same outcome: financial stability.

Secondly — for this very reason: insolvency considerations are subtle, nuanced and tricky — the opinion has to be “written and reasoned”. This too, has acquired its own gruesome meaning over the decades, and the closest colloquial translation to a layperson is “utterly unintelligible”.

A written and reasoned opinion cannot be a quick chat with your lawyer on a Friday evening over a beer. It must be on headed paper, and it must show the working. Your lawyer must put her back into it. She has to say why she has concluded that netting is enforceable, in detail. With receipts. Few lawyers will pass up an opportunity to drone on at length, and experts in the resolution of aleatory contracts are no exception.

For compensation for legal services is generally calculated by reference to the higher of the value added and the time spent^[7] — thought leaders can bellyache all they like about this, but it is true, has always been true, and always will be true — so to instruct a lawyer to perorate on a topic that is not wildly controversial is to ask the proverbial silly question. Lawyers like nothing better than giving silly answers. They will come in a 300-page sheaf, accompanied with a commensurate bill, and will say things like:

It occurs that, mainly because of the applicable limitations on asset allocation (spreading of risk) and also because the Investmentfondsgesetz contains specific provisions on the redemption of the Investment Fund’s units (and certain limitations/precautions in case redemption should lead to a liquidity problem), the Investmentfondsgesetz is based on the assumption that an Investment Fund may not become overindebted in terms of Austrian insolvency law (insolvenzrechtlich überschuldet) or illiquid (zahlungsunfähig). Accordingly, save for provisions that relate to an Investment Fund’s liquidation (Abwicklung) (e.g, in case the Investment Fund’s assets decrease below EUR 1,150,000 and the Investment Fund Management Company opts to no longer manage that Investment Fund and no substitute Investment Fund Management Company is appointed in accordance with the Investmentfondsgesetz), applicable law is silent in this regard. In our opinion this (historic) view somewhat neglects to take into account the risks that may be incurred by the Investment Fund Management Company, e.g. in relation to derivatives transactions that are entered into by the Investment Fund Management Company in its name and for the account of the holders of units in the Investment Fund (Anteilinhaber) in respect of a specific Investment Fund.^[8]

Now, we know lawyers resile from being categorical about anything if they can possibly avoid it. That includes even simple things, like “how contracts are enforced upon insolvency”. Your lawyer will take the instruction to “show her working” as an invitation to bury the actual conclusion. The opinion will be written and reasoned at the cost of being clear.

The rest, dear readers will be for the premium subscribers.

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Banca Valle del Silicone
Non era Lorenzo Medici
Io ho cedole fissate
Tu le hai variate
Vogliamo la copertura
Fissiamo la procedura

—Otto Büchstein, Eggfried

When we left off last time Silicon Valley Bank had collapsed. It burned through its “available for sale” portfolio of financial assets — mainly long dated U.S. treasury notes — to meet the surge in withdrawals it suffered when, in early 2023, the U.S. Federal Reserve — the central bankers’ central bank — hiked interest rates to tame inflation, and that caused the cheap money venture capitalists had been hosing at anyone with a pitchbook, a turtleneck and a compelling blockchain story, to suddenly dried up.

Suddenly all the bank’s customers needed their deposits at the same time.

That’s the deal with deposits: if customers want their money back, you must give it to them. If you don’t have cash on hand, you must liquidate assets. Silicon Valley Bank had ploughed its deposits into safe, long-dated, government-guaranteed bonds — good — but paying what were now uncomfortably low fixed interest rates — bad.

It could only sell them at a significant loss. A fixed rate bond’s “discount” to its redemption value is a function of two things: how far its coupon sits below current rates, and how long remains to maturity. The bank’s portfolio was well below market rates and, on average, very long-dated. This added up to a whopping “discount”.

You might have questions about that. For one, seeing as “borrowing short and lending long” has been the basic risk of banking since the Medicis, aren’t there tools for managing that risk? Couldn’t Silicon Valley Bank have, like, hedged themselves somehow, to avoid falling down this manhole?

Secondly, war stories are all well and good, but what do they have to do with close-out netting on an ISDA? Silicon Valley Bank was just a normal commercial bank, wasn’t it? Did it even have a swap portfolio?

Those are good questions and they are related.

Duration risk is something the Medicis would have understood and dealt with. It is the ultimate “known unknown”.

And there are things you can do to manage it. In fact, until 2022, Silicon Valley Bank did them: it hedged with “over-the-counter” contracts under which it would pay sums broadly equal to its fixed rate bond coupons, and receive floating rate coupons back. The bank announced its strategy in 2021, expecting rate rises from the Federal Reserve. As the market priced in rate rises, those contracts became more profitable.

These hedging contracts were, of course, swaps.

So, Silicon Valley Bank did have a swap portfolio. A big one. By the end of 2021, it was $15.2 billion in notional amount.¹

But over the course of 2022, Silicon Valley Bank risk managers believed rates had peaked. They systematically unwound almost all their interest rate swaps to realise mark-to-market profits.

This locked in one-off gains, but left the bond portfolio exposed to further rate rises. If, as the bank expected them to, rates eased the bank would realise even more profit. But if they rose further, the bank would be in a jam.

It is easy to be wise in hindsight. In Q2 2022, the Fed was only getting started with its rate rises. You can see the timing of SVB’s hedge unwinds below. It is the region in red.

So swaps did not cause Silicon Valley Bank’s downfall. To the contrary, the lack of swaps contributed by removing the main buffer that could have absorbed the coming rate shock.

You could say the lack of swaps was the proverbial “curious incident in the night time”.

Hedging interest rates: the boy and his shadow

She returned to the nursery, and found Nana with something in her mouth, which proved to be the boy’s shadow. As he leapt at the window Nana had closed it quickly, too late to catch him, but his shadow had not had time to get out; slam went the window and snapped it off.

You may be sure Mrs. Darling examined the shadow carefully, but it was quite the ordinary kind.

— J.M. Barrie, Peter and Wendy (1904)

This may sound trite, but it is still profound: interest is a consequence of lending. Interest doesn’t — until recently, couldn’t — exist without a corresponding disposition of principal from a lender to a borrower.2 Interest is to a loan as a shadow is to a boy: term loans cast one sort of shadow —fixed — and deposits cast another — floating — but both depend fundamentally on indebtedness. No Peter, no shadow. No loan, no interest.

Duration risk is the problem of trying to match fixed assets that throw one kind of shadow with callable liabilities that throw another.

If you could sell a fixed rate shadow, and buy a floating rate shadow, you would be covered. But how do you trade rates without borrowing and lending the principal sums they are derived from?

You might, if you lent fixed and borrowed floating over identical terms and for identical principal amounts to and from the same person: then the principal payments would offset perfectly. On the same day you borrow $15.2bn on a fixed rate, you lend $15.2bn on a floating rate, on terms that they will both be repayable simultaneously. No money needs to change hands.

This is an excellent solution: principal liabilities wash out to zero: the parties are paying and repaying identical amounts to each other on the same date — leaving only the residual interest rate exposures. The shadows remain; the boys cancel out.

But, alas, banks were left with a formal problem, occasioned by the way defaulting companies’ assets and liabilities are usually resolved in bankruptcy: it there were two standalone loan contracts one borrowed, one lent, each supported by valuable consideration and standing on its own as a sensible economic transaction entered at arms’-length, they would be treated for all practical purposes as distinct: one would be an asset and the other a liability, and they would sit on opposite sides of the balance sheet.

An insolvency administrator would naturally regard them as different things, having different consequences on the defaulting party’s bankruptcy.

A bankrupt’s liabilities are, of course, subject to recovery and resolution contingencies of the bankruptcy process. A creditor might get some or all of its money back; but it might not.

A bankrupt’s assets, on the other hand — its claims against its own debtors — are not. They are undiminished. Indeed, the more the bankrupt recovers from its debtors, the more it will have to repay its creditors.

So the insolvency process — which is there to protect creditors — would naturally prise apart loans owed by the bankrupt from those owed to it, even if certain pairs of loans were entered together and with a unitary purpose. An offsetting lender/borrower would have to repay one, but file a creditors’ claim in bankruptcy for the other.3

This rather mucks up the clever idea of cancelling out the two “boys” and being left with their offsetting “shadows”. A bank counterparty would have to hold regulatory capital against its whole loan asset. It would not getting any relief for the value of its offsetting loan liability.

In 1981, bankers at Salomon Brothers — who have since passed into JC mythology as the First Men — had two clients, IBM and the World Bank with exactly this problem, only in the converse to each other.

The First Men had a bright idea. They called it the “swap”.

Swaps

“I wonder,” Mr. Darling said thoughtfully, “I wonder.” It was an opportunity, his wife felt, for telling him about the boy. At first he pooh-poohed the story, but he became thoughtful when she showed him the shadow.

“It is nobody I know,” he said, examining it carefully, “but he does look a scoundrel.”

— J.M. Barrie, Peter and Wendy (1904)

Swaps are a really neat idea. They solve that duration risk — the one that has been with us since Lorenzo Medici — in a novel way without blowing up the balance sheet the way offsetting loans would.

The essential insight of a swap is twofold: first, find a single counterparty who has the opposite duration problem to you, and secondly, remove the principal exchange altogether.

Now you can both hedge your position. Neither of you needs to needlessly inflate your balance sheet.

Economically, an interest rate swap is identical to offsetting loans with the same person. The difference is a formal, but important, legal description: rather than the principal exchange being resolved by set-off, it is removed altogether. A swap is in no sense two inverse transactions: it is a single unified Transaction with no principal exchange at all.

There is therefore no claim for an insolvency practitioner to make for a “return of principal”. The “boys” are gone. We are left with only their “shadows”. The present value of the offsetting payment streams — the shadows — will fluctuate, but they will always offset each other.

So, is this where we talk, finally, about netting, of those offsetting rate flows, and implied exchanges of principal? Is that why we need close-out netting opinions? To reinforce the argument, somehow, that a swap should not be recharacterised as a pair of disguised, offsetting loans?

No.

That bit is settled: as there is no principal exchange inside a swap, there is nothing for insolvency administrators to claim. Unlike the “offsetting loans” structure, the individual “legs” of a swap do not make economic sense by themselves. You cannot view them in isolation. Rather, the fixed leg is consideration for the floating one, and vice versa. You don’t need enforceability opinions at this level, because here there are no cherries to pick.

The “cherry-picking” problem arises only when we try to boil down exposures between different swap Transactions between the same parties under the same ISDA.

The Single Agreement

In most financial instruments, the interest is pinned permanently to a disposal of principal. It is therefore always clear who is the creditor and who is the debtor, and they don’t change.

Loans, for a bank, are always assets: once drawn, the bank is always creditor and the borrower always debtor. There are no circumstances — not even negative interest rates — in which a loan asset could turn into a debt liability.

In the same way, a bank deposit is always a bank liability. A depositor, as depositor, never owes the bank.4

Swaps are genuinely bi-directional: they can be either assets or liabilities. You cannot predict who will owe whom at any point in the future. If rates fall, the floating rate payer will be “in-the-money”. If they rise, the fixed rate payer will.

This presents a challenge, or an opportunity, when it comes to aggregating swap exposures under an agreement. Some will be positive, and some will be negative. Ideally, the counterparties should want them to offset.

And now, finally, we can talk about close-out netting opinions. This is the offset they address.

In its day the ISDA Master Agreement was a revolution. The printed form has all kinds of arcane and clever tricks but the “single agreement” concept, set out in elegant and simple language in Section 1(c), is its masterstroke.

(c) Single Agreement. All Transactions are entered into in reliance on the fact that this Master Agreement and all Confirmations form a single agreement between the parties (collectively referred to as this Agreement), and the parties would not otherwise enter into any Transactions.

What this does is to claim the same status for all Transactions as the “swap” concept did for offsetting loans: to say that each of these Transaction “Exposures” is not an independent asset or liability, but is entered into in reliance on the agreement that all Transactions are to be summed down to a greater whole, being the total aggregate exposure under the whole ISDA. There is to be no “cherry picking”.

If this was as far as it went, it might be a bit lame: this does not, of itself, remove a “central offset” to render the separate Transactions co-dependent, the way cancelling the principal exchange converted two offsetting loans into a single swap. It just says, hey, we go into this on the understanding cherry-picking is not allowed, okay? Insolvency laws have a habit of overriding inconvenient contractual provisions. Bankruptcy is an alternative universe: normal rules to not apply. See “Bankruptcy is a phase transition”.

But the ISDA has a second trick that goes some way to achieving that effect. It is buried in Section 6(c)(ii):

(ii) Upon the occurrence or effective designation of an Early Termination Date, no further payments or deliveries under Section 2(a)(i) or 9(h)(i) in respect of the Terminated Transactions will be required to be made, but without prejudice to the other provisions of this Agreement. The amount, if any, payable in respect of an Early Termination Date will be determined pursuant to Sections 6(e) and 9(h)(ii).

See what’s happening there? Can you see the magic?

Kind of buried, right? What is is saying is that upon close-out, the Terminated Transactions are just terminated and nothing is required to be paid under them. The Transactions just vanish in a puff of smoke.

The Close-out Amounts are mystically conveyed somehow to the main Master Agreement, where they are determined not as final amounts due under the Transactions — by this stage, the Transactions have vanished, remember — but as calculation inputs to an amount due under the ISDA Master Agreement itself.5

The intention here is to defeat arguments that, “for this set of out-of-the-money exposures, you are an unsecured creditor in the queue, but for this set of in-the-money exposures, you must pay up right here, right now.”6 Instead, all those amounts are treated simply as inputs to a single termination calculation for the whole agreement due under the “architectural” Master Agreement, not the individual Transaction. This, by the way, is why you cannot unilaterally terminate a Master Agreement — you need it, at all times, for this purpose.

That is where we leave off this episode — we will return next week to look at the mechanics of netting.

But before getting to that we need to go right down into the elephants and turtles of what banking is all about.

For to understand why we need close-out netting opinions we must understand what close-out netting does. To understand what close-out netting does, we must understand the point— the importance — of capital adequacy. To understand the imperative of capital adequacy, we must have our heads around the profound structural problem faced by every credit institution: “borrowing short and lending long”.

Fundamental intermediation

To understand that problem we need to understand the basic function every bank plays in the economy, of taking — with permission, of course — money from those who have more than they need, and giving it — for a fee — to those who don’t have enough.

This fundamental business of banking is intermediation. Depositors — those with too much money — lend it to the bank, in return for deposit interest. The bank then lends that money — or, at least, a sum equal to most of it, to borrowers — those of its customers who don’t quite have enough. The bank lends to them, also, in return for interest. I don’t imagine this will come as a great surprise to anyone.

As long as the borrowers are as good as their word and pay back what they owe, all is mostly well. If the borrowers can’t pay their money back, then the bank will have a harder time repaying its depositors. That much is obvious. But even if they can, the banks face an embedded structural problem. Generally, banks take in deposits “on call”. They are repayable to depositors on demand: Just stick your card in the ATM and you have have your savings back. But when banks lend money to their customers, they tend to do so on term loans: they can’t ask for their money back when ever they want it. They must wait until the end of the term.

This can present banks with a cashflow problem, especially if they happen to field a large amount of withdrawal requests from depositors at the same time. Usually, this doesn’t happen: a bank’s deposit base tends to be fairly stable, and across the bank inflows and outflows on a given day are more or less balanced. But occasionally circumstances can contrive to change that, and things can get pretty spicy, fast.

We can best explore this by the sad tale of Silicon Valley Bank.

Interlude: The sad tale of Silicon Valley Bank

SVB committed one of the most elementary errors in banking: borrowing money in the short term and investing in the long term.

—Larry H Summers, 14 March 2023.1

There are any number of ways to measure the size of a bank: by number of customers, depositors or employees; by branches, by geographic spread or by aggregate value of customer deposits — but the conventional one is total asset value — the aggregate value of all the investments the bank has made — much of it with those deposits.

By that measure, in March 2023 Silicon Valley Bank, though founded only 40 years earlier, was the 16th largest bank in the U.S.

If you measured Silicon Valley Bank by its number of depositors, it wasn’t nearly as big. Whereas JPMorgan has something like 90 million customers, Silicon Valley Bank had about 40 thousand. And whereas the average customer balance at JPMorgan, across business and retail accounts is about $20,000, the average customer deposit balance at Silicon Valley Bank was a shade under $4,000,000.

I can save you a bit of maths here: Silicon Valley Bank was a tenth of JPMorgan’s size, but had one thousandth as many customers. And those customers were not diverse. They were not, like JPMorgan’s customers, a scattered distribution of miscellaneous butchers, bakers and candlestick makers: Silicon Valley Bank’s customers were all techbros. They all knew each other. They were all directionally positioned the same way. They all had lots and lots of spare cash.

If you are JPMorgan, the beauty of your retail banking portfolio is that it is not at all concentrated. There are millions of butchers, bakers and candlestick makers, and they all deposit and withdraw their tiny amounts over the month, based on their own unique needs and circumstances. Because they are, for the most part, independent of each other, the overall effect is to smooth out all the volatility in your overall balances. Your “deposit base” is stable. It’s predictable.

Silicon Valley Bank was very different. It had thousands, and not millions, of customers, and each one deposited a lot. Their deposit balances ran to millions. It was a really concentrated little bank.

What was special about SVB? What was special about its customers? What kind of freak keeps millions of dollars in a checking account? Well, the clue is in the name.

Silicon Valley Bank was founded in 1983 by a couple of Bank of America executives who spotted an opportunity to provide banking services to the then nascent “technology industry”. At the time, “Silicon Valley” was a fun name for a rabble of dope-freaks, dropouts and hippies mucking around with soldering irons and BASIC in Cupertino garages. These cats struggled to get accounts at Wells Fargo and JPMorgan. The new bank met their needs.

Roll forward 40 years and it’s a different story. Silicon Valley Bank is the go-to bank for the VC crowd. Anyone who was anyone banked there. An SVB card was as much a part of the techbro clobber as the black turtlenecks, immortality vitamins, slap-head anarcho-libertarian ideology, sack-hopping altruism and the simulation hypothesis.

But only techbros banked there. Silicon Valley Bank didn’t collect deposits from many butchers, bakers or candlestick makers. It didn’t really want them: when you have queues of unicorn techbros queueing up to stash their cash with you, who has time to onboard the little guys?

As time passed, Silicon Valley Bank steadily “lent in” to its niche: it provided startup advice. It made introductions. It had great VC contacts. It did off-the-cuff in consulting. It was part of the valley ecosystem. Some venture capitalists made banking there a condition of funding.

Techbros are joiner-inner types at the best of times: this was a network effect on steroids.

By 2020 software was eating the world, just like the VC snapperheads said it would, and money was abundant. There was the metaverse, crypto and nascent AI: as long as you had an account at SVB, VCs did not discriminate. They threw money at WeWork, WireCard and Theranos and it was fine. They would happily throw money at you. All you needed was a pitchbook, a hoodie and a compelling story about blockchain.

The name of the game was “first-mover advantage”: move fast and break things. Scale. Lever. Dominate the your space. Build a moat. Cash burn was a badge of honour. If you ran out, you just raised more.

So Silicon Valley Bank’s main customers, the techbros, had lots of cash. Like, lots. In the U.S., retail bank deposits up to $250,000 are government insured against bank failure by the Federal Deposit Insurance Corporation. For regular banks, most of their deposits are FDIC-protected: only 20% of retail deposits exceed the quarter of a million dollar threshold. You’d expect that: who puts quarter of a mill in a savings account?

SVB’s customers, that’s who. Ninety percent of SVB’s deposits were over the $250,000 FDIC threshold.2 There are two things to take from this: firstly, SVB deposits were stupefyingly big and secondly, they were at risk if SVB should get into trouble. There would be no government bailout.

Everyone at Silicon Valley Bank was depositing cash. Almost no-one was borrowing.

This is not normal for a bank. Borrowing and lending tend to balance out. When money is cheap, people feel good. They borrow to buy stuff, and pay the borrowing costs out of their income. They put things on the credit card. They buy houses this way. Cars. They put things on hire purchase. They put capital into their businesses. For this, they go to the bank. That’s what a bank does: matches depositors and borrowers. Yin and Yang.

But techbros aren’t like normal people. They don’t get money from banks: they get it from venture capitalists. Techbros are — were — structural lenders, not borrowers.

So, Silicon Valley Bank had an odd problem: what to do with all these excess deposits? Between March 2021 and March 2022 — in a single year, in the middle of the Pandemic — SVB’s deposit base doubled. It was being given deposit cash in a near-zero interest rate environment. Its interest costs were low, sure, but it had some, and overheads. Without borrowers, it had to find somewhere to park that cash and some income to pay its bills, return a profit, and yet be able to meet deposits if customers suddenly wanted their money back en masse. Usually, customers don’t do that — retail banking is a boring business — but SVB was special. If there could be a secular inflow in, there could be a secular inflow out.

SVB had a credible answer. It would invest the deposit cash in U.S. government bonds and highly-rated mortgage-backed securities. These were, it thought, a better bet than mortgages and business loans anyway.

The gig for normal banks is to lend that deposit cash to home buyers and businesses. These investments carry credit risk. Businesses can fail. If you’ve lent out on a mortgage, you run the risk your borrower can’t pay you back, and the property collapses in value. Even if it doesn’t, they are long-term commitments. You can’t get your money back until the term expires. And that term might be as long as 30 years.

By contrast, U.S. Treasuries are safe. They are as safe as it gets: Uncle Sam don’t go bust. They are reliable: they pay fixed, regular coupons. They are liquid: you can sell them in a day and get your money back.

For a commercial bank without borrowers, they looked like a sensible hedge. I dare say the managers and executives at Silicon Valley Bank congratulated themselves on their prudence.

Still, short-dated government bonds in a low interest rate environment don’t pay much interest.

This is not the place to talk about yield curves in detail, but to generalise outrageously, the longer you are prepared to invest your money, the higher your interest rate tends to be. The “yield curve” usually slopes up and to the right. Silicon Valley Bank put all its deposit cash in 10-year U.S. treasury notes. All seemed in order.

There was one extra little funny. Silicon Valley Bank was big — but not colossal. It was not a systemically important financial institution, or “Stiffy”.3 U.S. regulators did not think it was big enough to present a real threat to the financial system.

This meant it avoided certain capital regulations that applied to bigger banks. One was the “liquidity coverage ratio”. This requires a bank to keep a certain portion of its deposit obligations in “high-quality liquid assets” on hand at all times — cash or cash like instruments, which doesn’t include long-dated treasuries – to meet unexpected withdrawal requests. If market conditions suddenly change and customers suddenly all want their money, a bank can use its “liquidity buffer” to ride out the storm.

In 2019, Silicon Valley Bank had lobbied for an exemption from these coverage ratios for banks with less than $250bn in assets. For reasons that, no doubt, U.S. bank regulators would come to regret, they granted it that exemption. As a result, SVB kept very little liquid cash on hand. It ploughed it all into ten-year Treasury notes and highly rated mortgage-backed securities.

Then came COVID. At first it seemed a good thinrg. SVB’s deposits tripled—from $61 billion in early 2020 to $189 billion by 2022. It doubled down on its strategy.

The inflation rate that didn’t bark in the night-time

“Is there any other point to which you would wish to draw my attention?”
“To the curious incident of the dog in the night-time.”
“The dog did nothing in the night-time.”
“That was the curious incident,” remarked Holmes.

— Sir Arthur Conan Doyle, The Adventure of Silver Blaze

All good things must end and the pandemic turned out to be the final straw that broke the zero inflation madness. Ever since the global financial crisis in 2008 governments everywhere had been helicoptering cash onto their bin-fire economies with, seemingly, no adverse inflationary effects.

The idea that low interest rates cause inflation seems baffling for a moment, but makes sense when you think about it. Inflation is prices going up. Prices tend to rise when demand outstrips supply. Demand rises when people spend. People spend when money is cheap. Money is cheap when interest rates are low. Low interest rates tend to push inflation up.

And yet for fifteen years money was cheap. With every new crisis, central banks firehosed their economies with it, but inflation barely moved. No-one had a good explanation. Over time there was a kind of tacit assumption that, somehow the link between cheap money and big inflation was broken.

So when the economic world ground to a juddering halt, once again, in March 2020, central bankers knew the drill. They went to their printing presses as usual.

But this time inflation shot up. This took central banks by surprise. Central bankers have one basic lever to control inflation: interest rates. Just as cheap money boosts inflation, expensive money kills it. Around the world central bankers hiked interest rates. Fast.

Duration mismatch: the fundamental risk of banking

Borrowing short and lending long is not — despite what the former secretary to the U.S. Treasury had to say about it on Twitter — an elementary error, but the very fundamental premise of banking. Banks cannot avoid it. That is what they do. By its fundamental nature, it is that exact risk — “duration mismatch” — that the service of “banking” presents to those who engage in it.

To see why we need to go one layer of turtles deeper, readers.

Banking is the business of reallocating capital. Banks borrow money from those in the community who don’t need it and lend it to those who do. A bank hoovers up all those for-now-unneeded deposits, loafing around in savings and cheque accounts, consolidates then and then lends them out, usually in sizeable slugs and for sizeable terms, to those who need investment.

In their most simplistic terms, banks intermediate between lenders — “depositors” — and borrowers.

The priorities of depositors are different to those of borrowers.

Depositors give up comparatively small balances they don’t need right now in return for interest, but on condition that they can have the money back whenever they want it. Monthly wage packets come in and then get salted away over the month. Generally speaking, a bank is obliged to return deposits on demand, and a failure to do so is a payment default.4

In the normal run of things, banks are quite good at predicting when and how much money their depositors, en masse, will need to withdraw. Their “deposit base” tends to be stable over a long period. This means that banks can, with reasonable confidence, use a large portion of their deposit base to make long-term investments.

Which is just as well, because “long term money” is what bank borrowers want. They want to lock up the money they borrow. They want committed bank facilities to buy property and invest in working capital. These projects have a much longer term: mortgages may be twenty or thirty year arrangements. Borrowers need to know the money they borrow, and the price they have to pay for it, is committed.

So: banks borrow from depositors “short” — overnight, or on call — and lend to their customers “long” — for pre-agreed terms.5

This creates what lawyers call “duration risk”. If all the depositors suddenly ask for their money back at once, and it is tied up for twenty years, the bank is “cashflow insolvent”.

In the ordinary course, banks manages these risks by diversifying: they have millions of depositors and tens of thousands of borrowers, and the behaviours and repayment schedules of both are predictable enough for the bank to manage its cashflows notwithstanding the duration mismatch, as long as it maintains a sensible “liquidity buffer” of free cash to cater for unexpected spikes in withdrawals.

If it’s that easy, then how does anyone get it wrong? Every now and then, banks do. Silicon Valley Bank did, badly.

On time being money

Hey, Rick? Time is money, right? I know “standing on the landing” may be a great song title, to me it’s just a tax loss.

—Mike, The Young Ones, 1984.

The general ideal of banking is to earn more interest on loans that you pay on deposits. This is, in essence, how banks make money. Deposits usually pay an interest calculated on an overnight rate. Bank loans are usually fixed for much longer periods.6

While this creates “duration risk”, as we’ve seen, we’ve also seen that in ordinary times it can be managed: banks run a “bid/offer spread” between lending and borrowing rates for one thing, and for another, at any time long-term interest rates, at which they lend, tend to be higher than short term ones, at which they tae deposits. The interest rate “yield curve” at any time usually slopes up and to the right.7 Therefore, structurally, they should be profitable most of the time.

This not always true. And the whole yield curve can move upwards. Today’s overnight rate could be higher than last month’s ten year rate. This could create a problem: a bank could be stuck with a portfolio of low-interest investments which it has to fund with high-interest deposits. If the overnight deposit rate unexpectedly spikes, a bank will have to raise its deposit rates, to stop its borrowers shopping around for a better rate, but will be stuck with its lending rates as they are. This can create, at least in the short run, a problem for the bank, unless it has enough cash on hand to meet the interest shortfall until is sorts itself out.

Things would be even worse if the interest rate spike was accompanied by a surge in withdrawal requests.

At this point let’s go back to Silicon Valley Bank. It is March 2023.

Second interlude: the sad demise of Silicon Valley Bank

Meanwhile, in Silicon Valley

Meanwhile, in Silicon Valley, that weird low-inflation, low-interest-rate, cheap-money environment — which for a decade had prompted cone-headed VCs to swamp money at anyone with a pitchbook and a turtle-neck — ground to the same juddering halt. The funding dried up. No more Series D rounds.

Everything still might have been okay for Silicon Valley Bank had it been able to sit on its low-yielding treasury securities, as it intended to, until they matured, riding out the temporary blip in interest rates. But that depended on depositors being cool with leaving their money in the bank.

That, too, might have happened, had it been JPMorgan and its customers a widely distributed, unconnected bunch of butchers and bakers with chump change in their checking accounts.

But Silicon Valley Bank’s customers were not like that: they were homogenous, tightly interconnected and weird — as in “western, educated, industrialised, rich, and democratic” weird, but also as in “freaky tech-bro taking pills to be immortal” weird — and all of them had unfeasibly large balances that weren’t covered by FDIC insurance.

Techbros suddenly found they needed to raid their bank accounts to make payroll. And they wanted their money, in any case somewhere a bit safer.

Silicon Valley Bank started shipping lots of withdrawal requests. It had lots of liquid US Treasuries it could sell, if it needed to, to fund withdrawals. No great panic, except for one thing: being long-dated fixed rate bonds, their stated interest rate was low. Their “present value” was also significantly under water.

To fund the withdrawals Silicon Valley Bank had to sell part of its U.S. government bond portfolio at a $1.8BN loss.

It announced plans to raise capital in the market to shore up its balance sheet and reassure investors — but that announcement had exactly the opposite effect.

All hell broke loose. All those techbros scrambled to pull their money out.

On 9 March 2023 Silicon Valley Bank suffered a bank run. The next day regulators shut it down.

Coda: call me “Lucky”

As I sit, staring into this liquid amber
Ripples move out to the edge of the glass.
Is that, really, your reflection in there?
I just want to jump into the warm depths
And be there with you
One more time.
Oh, alright.
Hit it, boys —

—Blondie, Here’s Looking At You (1981)

Silicon Valley Bank’s sudden collapse is illustration enough of the non-linear, hard-to-predict, tightly-coupled nature of complex financial markets. But it wasn’t done. Ten days later, half a world away, there would a final twist.

Ripples were moving out to the edge of the glass. On the 12th of March, Signature Bank — another darling of the tech crowd, with a surprisingly similar idiosyncrasy — also failed. Fear spread. The credit market had some kind of acid flashback to 2008. Was this the start of another banking crisis? Eyes fell on the weaker banks around the world.

Attention fell on one. The old warhorse Credit Suisse — battle-scarred, woozy, punch-drunk and unsteady on its feet after repeated drubbings — finally hit the canvas. Granite-chinned old “Lucky” had taken a beating in pretty much every catastrophe of the prior decade: Archegos, WireCard, 1MDB, Mozambique Tuna bonds, Greensill, Abraaj, Madoff, to name a few and got up every time.

This time, for once, the blame lay elsewhere. But this time, the old dog wouldn’t get up.

The social contagion problem

Hamlet: Why, then, ’tis none to you, for there is
nothing either good or bad but thinking makes it
so. To me, it is a prison.

—Hamlet, II, ii

Fulfilling the important community role that they do, banks are vulnerable to social contagion. If depositors form the opinion that they might not repay their deposits, they are likely to withdraw them. Depositors — even unweird ones — talk. They listen to the radio and read the newspaper. They are on Twitter. Word can spread quickly. Very soon there can be a line of depositors queuing up outside the bank.

This is inevitably a bad thing, not just for the bank, but also the depositors. No-one wins out of a bank run.

For the longest time, bank regulators have required banks to organise their balance sheets to reduce the risk of duration mismatches — and reduce the risk of customers being worried there might be a duration mismatch, which is just as important.

As long as they aren’t worried about duration mismatch the “ordinary” balance of loans and deposits will tend to be fairly stable.

A very simple way which banks, and bank regulators, can reduce this risk is by requiring banks to hold a certain amount of cash in reserve. If a bank keeps some of that deposit cash “on its balance sheet” to cover for unexpected outflows when horrible things happen. One horrible thing that can happen is the failure of a derivative counterparty. Counterparties can have surprisingly large “exposures” to single swap counterparties — see the series on Archegos — so they need to have money on hand to cover that contingency.

But how much? How would you calculate it?

It is one thing to be owed money by a bankrupt counterparty — that’s the oldest problem in banking — but what if you say your counterparty owes you, but its insolvency administrator looks through your “single agreement” to all the transactions, and tells you that you you owe the bankrupt counterparty?

That would be bad, right?

And what if it said it added up all your “out of the money” transactions, and you owed it twenty times what you were claiming from it?

This is the risk that close-out netting addresses. We will look it closer in the next instalment.

The music

The audio version of this piece makes lots of extra in-jokes (if you enjoyed this please do listen to it — it took ages to edit!) and to do that borrows some of JC’s favourite tracks. So you can listen to them properly, and the artists are suitably remunerated (thanks guys!) I have put a playlist together. Here it is:

You’re all here for eternity which, I hardly need tell you, is a heck of a long time.

—Rowan Atkinson, Welcome to Hell

Every now and then I field an unsolicited offer from someone to help me with “search engine optimisation”. This person says something along the following lines:

“In the competitition for attention on the world wide web, getting to the top of the google search results is more important than ever. I can help boost your site in search algorithms, so you rise above your competitors.”

Smugly, I always tell these people the same thing:

“Look, chump: I write weak satire about financial derivatives. I don’t have any competitors. No-one else is that stupid.”

The JC’s basic gig is to investigate the background context about things that are usually taken for granted — or ignored — to shed light on the business, economics and rationale of capital markets activity.

It is all pretty arcane, dry stuff. By design, I tend to think: the dense thicket of bumferous tedium is an imposing barrier to entry — “moat” is the latest buzzword. It keeps insiders at an advantage. My own attention-span is short so, while I was scaling that barrier, to keep myself interested, I resolved to make it fun to write — and therefore fun to re-read. There’s a mnemonic quality to it too: the more colourful you can make it, the easier it is to remember.1

So the JC presents material in an off-beat way. Since industry is populated, largely, by “on-beat” people — the financial services industry doesn’t exactly encourage loose cannons — I often wonder who my audience is. The answer I usually settle on is, “me”. But there is a small band of fellow travellers out there. The loose cannons. The inquisitive. The easily bored. I know it. You keep your cards close, but you know who you are. So I box on.

In any case The Jالی Contrarian™ started as a handy, non-linear way for this low-trajectory loose cannon to store “tacit” knowledge as he went along: crib notes, good practice, bad practice, old wives tales, wry observations and functional know-how about who does what, why, and the practical ins and outs and theoretical background to these mad legal contracts. And here, fifteen or so years later, we are.

The thing about tacit knowledge is that it is tacit: forty or more years of people doing, but not writing down, this stuff means there tend to be large holes in the record, here and there, where institutional memory has disappeared altogether. Here I have feely made stuff up, a series of “just so” stories to put this into some kind of context, even if it is a false one. I have recently completed a long series about collateral that was like that.

It is not easy to write entertainingly about swaps. Rib-ticklers do not exactly leap off the page: there are no star-cross’d lovers, dark and handsome strangers, boy wizards or bunny-boiling sociopaths. Actually, I am not sure about this last one: there is something of the Hannibal Lecter about those prepared to write tomes about aleatory contracts, a topic we will shortly get to.

But even so, there are levels of dullery. Variation margin is one thing: you can crowbar in Jimi Hendrix anecdotes and Monkey! references into that.

But close-out netting? We are on a different level here, readers: it isn’t just arcane and technical: it is, at a fundamental level that even the most ardent ninja will feel to her marrow, stupefyingly dull.

So we will try to liven it up with a little Kabuki theatre for you all, from the pen of that finest exponent of finance fiction, Hunter Barkley. This is from his forthcoming novella Close-out! Close-out! Close-out!.

The warehouse was dark. Condensation dripped. Water pooled. Steam hissed.

Algy led. Boone stayed close. They ran silent: matched strides. Tracked footprints. They moved like feral cats.

They went room to room. Algy cleared left and right. He cleared out the corners. He waved them through.

They made it to the central chamber. It was dark. They went in.

A solitary downlight picked out the Hackthorn goon: Cass Mälstrom, C.O.O. He sat at a card table in the middle of the floor. He had game. He was ex-McKinsey. A real thought-leader. He sat tight. He didn’t move.

Boone coughed.

Mälstrom looked up. “Is that you, Boone?”

“Yes, Cass, it’s me.”

“You alone?”

“Look, I just want to sort this out. I didn’t want this — none of us did — but you gave us no choice. Why didn’t you pick up the phone, Cass?”

“I — I been busy, Opco.” Mälstrom seemed edgy. He clocked Algy. “Who—hey, who’s that? I said come alone! I said no fuzz, Boone.”

“Algy’s not a copper, Cass! He’s my bagman. He’s got what you want, if you’ve got what we want.”

Boone nodded at Algy. “Show him, Al.”

Algy opened the kimono. He flashed his trench. He dangled his wares. MTMs glittered from the lining on either side.

Mälstrom whistled. “Pretty.”

“So, we got ours, Cass. Now, how’s about you?”

Mälstrom swallowed. Beads pricked on his pink forehead. “It’s — it’s a—all here.” Mälstrom seemed suddenly nervous. He motioned at a calico sack on the desk, next to a fruitbowl.

Algy muttered, “What’s with the summer fruit, Opco? I don’t like it. Something ain’t right.”

Boone held up a finger. “We showed you ours, now you show us yours. Just let us see what you have, Cass, and we can be on our way. We just want what’s owed to us. We don’t want any trouble.”

Another voice came out of the dark. Urgent. Malicious. “Who said anything about trouble?”

A loud click. Boone knew at once: it was the sound of a bump-stock OSLA being cocked.

“Wh—?”

“Not so fast, Mr. Boone.”

Boone said, “I say, who is this?”

“Your worst nightmare.” A long glinting copper barrel moved into the spotlight throw and pressed against Mälstrom’s temple.

Mälstrom squeaked. “Just do what she says, Opco. Just do it. Sh — she’ll kill me! I’ve seen what she can do! She’s not kidding around!”

A tall woman in black chiffon moved into the light. “I don’t believe we’ve met, Mr Boone. I’m Emsworth, of the O. A.”

“A banko!” hissed Algy.

“Yes, Mr. Farquhar, a “banko”. A liquidator. A receiver with a mandate to resolve. Hackthorn Capital Partners L.L.P. is my baby now. My baby, and your problem. Now, let’s have your MTMs, Mr. Boone. Nice and slow. Come along.” Emsworth reclicked the OSLA and shoved it against the hedgie’s temple.

Mälstrom re-squeaked. “Do it, Boone!”

“Put down your money, Mr. Boone.”

Boone nodded to Algernon.

Carefully, Algy placed the MTMs down, one at a time. “I did all the calculations just like you said I should, Opco, under Section 6(d). I gots all the statements.”

“Ok, Al, count them off.”

Algy busied himself around the table, placing bags in a row. “Here’s our forty five for you. For this next one, you have to put down twenty six for us. We put twenty two for you. You put eighty five down for us.”

It took fifteen minutes. Algy stood back, proud of his work.

Emsworth smiled. “Goooood. I like it when people are sensible.”

“All right, Ms. Emsworth. You’ve had your fun,” said Boone. “Now it’s your turn.”

Algy nodded. “Right. So now you gots to put down your OTMs too. The ones for us.”

Emsworth chuckled. “I don’t think so.” She swept Algy’s piles into a black Samsonite and snapped the lock.

“Hey!” squeaked Algy.

Boone took a step forward.

Emsworth re-cocked the OSLA. “Easy, now: let’s not do something we’ll any of us come to regret, Mr. Boone.”

Boone stopped. “All right, all right: but this is not how it’s supposed to work, Ms. Emsworth. That’s not the deal. We settle down. We net, positives against negatives. Tell him, Cass.”

Mälstrom whimpered.

Emsworth twisted her face into a long, deep, cruel laugh. “Oh, Mr. Boone. You poor deluded fool. This is Guatemala. You’re not in Kansas any more.” She reached over to the fruitbowl, plucked a cherry and raised it slowly to her thin lips.

“Jeepers, Boone, look out! I think she’s — cherry-picking!” cried Algy.

Emsworth smiled and bit. The fruit burst. Crimson juice ran down her chin.

“I say, Mr. Boone, your little monkey is perceptive. I am “cherry-picking” — just as I am entitled to do.”

Opco said, “Now look here. This is a single agreement! We square up. That is the deal! What about your OTMs? What about the money you owe us?”

“But, Mr. Boone: we are through the looking glass now. We hav emade the phase transition from the normal world into bankruptcy. The normal rules do not apply. Now, if you’ll excuse me, I have what I need, and I have a plane to catch.”

“What about my money, Emsworth?” Emsworth yanked a circuit breaker and another downlight glared. “If you want your OTMs you shall have to wait for them. And fight for them.” The spot revealed a rusted metal cage. A dozen big cats paced inside: leopards. Tigers. They growled.

“What the hell is this”?

“Can’t you read, Mr. Boone?”

There was a stencilled sign above the cage: “CREDITORS”.

“Mr. Mälstrom’s creditors. You are welcome to join them. They are all looking a bit peckish, don’t you think, Mr. Boone? Shall we feed them?”

Emsworth dangled the MTMs.

“Stop this! Tie them up!”

“Tie them up? Oh, no, Mr. Boone. That would never do. They are unsecured. If you want your money, you’ll have to scrap them for it.”

Emsworth lobbed the calico sack into the cage. The big fat cats fell upon them in a threnody of gnashing maws.

“All yours, Mr. Boone! Good day!”

Official Assignee, First Class M. T. Emsworth threw the circuit breaker. The room went black to the reverberating sound of her calculating laughter.

---

“Nein!” Ogfried sat bolt upright, drenched in sweat.

A light clicked on. He blinked.

The Gräfin stirred, rolled over, pushed up her sleeping mask and regarding her husband painedly. “Vot is eet, darlink?”

Herr Ogfried Schümli Pflümli ranking workstream lead of the Basel Committee’s special execution disaster planning taskforce, grunted.

The dripping warehouse was gone. The lions were gone. The calculating Guatemalan receiver, M. T. Emsworth, was gone. He was in his bed, a comfortable four-poster in his favourite suite at The Meadows. A gossamer curtain billowed by an open window. Outside, the forbidding crests of the Jungfrau were bathed in starlight.

The Gräfin said, “Ach —you hef a nightmare, sweetheart.”

Schümli Pflümli blinked again. His suite was still there. No lions. But — it seemed so real. So urgent. So dangerous. So — plausible. Was it really — could it have been — just a dream?

“Nein,” he said to himself, out loud. “Zis could really happen. We must do something.”

It is Schümli Pflümli, in Barkley’s telling of it, that we have to thank for the current, grisly state of the world.2 The poor man saw the risk that bankruptcy administrators posed to the financial universe, and made it his life’s mission to stop that catastrophe ever happening, by requiring comprehensive legal opinions on the effectiveness of the Single Agreement for every counterparty in every jurisdiction, for every master agreement.

By one measure this has been the most successful regulatory innovation in the history of finance: as far as I know, not a single master agreement has had its integrity challenged in insolvency by any liquidator anywhere in the world.

But on the other hand, some people say that, as a disguise, elephants paint the soles of their feet yellow and hide upside down in custard.

As far as I know, no-one has ever seen an elephant hiding upside down in custard, either.

For all that, though, netting and capital adequacy is a very useful lens to understanding how the market works, and why it takes the shape it does. The whole palaver is also, in my view, badly in need of fixing.

Today we start to confront, in all its majestic, horrifying glory, the problem of close-out netting.

The netting problem

This topic — “the capital treatment of close-out netting, what is wrong with it and how to fix it,” has been flapping around my head like a wounded pigeon for a decade.

All in-house sales & trading lawyers will know the problem well, for it is their problem. Our problem: to identify, gather, read, analyse and summarise “written and reasoned” close-out netting opinions covering every master netting agreement in the bank’s portfolio. These opinions might be anything from thirty to three hundred pages long. Each.

Now, no-one wants to read a netting opinion. No-one. Given the lengths their authors go to spin the blessèd things out it might seem improbable, but I don’t believe anyone wants to write a netting opinion, either.

But they do. By the boatload. In the year of our Lord 2026, a good-sized trading broker-dealer is likely to have hundreds of thousands of master agreements. Each of them must be covered. A given firm may need several hundred permanently-updated opinions. The sheer drudgery of this exercise defies simple description. You have to start reading just one of these opinions to understand it. So, actually, let’s do just that. To make the point. Here is sample paragraph, from page 26 of a 107-page opinion:

It occurs that, mainly because of the applicable limitations on asset allocation (spreading of risk) and also because the Investmentfondsgesetz contains specific provisions on the redemption of the Investment Fund’s units (and certain limitations/precautions in case redemption should lead to a liquidity problem), the Investmentfondsgesetz is based on the assumption that an Investment Fund may not become overindebted in terms of Austrian insolvency law (insolvenzrechtlich überschuldet) or illiquid (zahlungsunfähig). Accordingly, save for provisions that relate to an Investment Fund’s liquidation (Abwicklung) (e.g, in case the Investment Fund’s assets decrease below EUR 1,150,000 and the Investment Fund Management Company opts to no longer manage that Investment Fund and no substitute Investment Fund Management Company is appointed in accordance with the Investmentfondsgesetz), applicable law is silent in this regard. In our opinion this (historic) view somewhat neglects to take into account the risks that may be incurred by the Investment Fund Management Company, e.g. in relation to derivatives transactions that are entered into by the Investment Fund Management Company in its name and for the account of the holders of units in the Investment Fund (Anteilinhaber) in respect of a specific Investment Fund.3

And that is just one opinion, for just one agreement type, in just one jurisdiction. Capital regulations require banks to have up-to-date opinions like this for every jurisdiction in which they trade, for every type of counterparty, and every type of master agreement.

Having, like many of you, lived with this exact problem for years, and having, for a sales & trading lawyer, an unusually low boredom threshold — I am “constructively lazy” — In my tours of duty I spent a lot of time trying to work out how to make this job less of an imposition.

This isn’t simply a problem of tedium. It is a real and present problem of cost. The world-wide collective enterprise devoted to gathering, wrangling, interpreting and applying these netting opinions is a full-blown military-industrial complex. Its total annual cost to the industry is hard to measure but surely runs to hundreds of millions, if not billions. That does not account for the psychological toll it takes on the thousands of well-meaning lawyers, treasury analysts, technologists and contract negotiators who are drawn into its slavering maw.

Now the financial markets owns some of the brightest and most creative structuring brains around. So why this problem hasn’t been solved before now?

That question has puzzled me. My own view is that there are myriad interlocking reasons.

To suffer is divine

For one thing, lawyers are a Calvinist bunch. There is nothing they like better than whipping themselves with cold spaghetti. There is a school of thought, widely held, that to suffer is divine: that if it isn’t painful, fiddly, counter-intuitive and complicated, it somehow can’t be any good for you. There is nothing more redolent of a devotional flogging than settling down with A Memorandum of Law on the Validity and Enforceability of Close-Out Netting under the ISDA Master Agreements under Italian law.

Amongst sales & trading lawyers this translates to the weary resignation that wading through pages and pages of an academic Belgian peroration on aleatory contracts is some how cleansing, noble, good and necessary. To suggest there might be a better way is seen as indicating weakness: a want of moral fibre or intellectual rigour.

Netting opinions are an inhouse lawyer’s cold-water swimming regime, therefore. As hateful as they may find them, it just isn’t done to complain.

Somebody else’s problem

For another, a bank’s “netting problem” is dispersed laterally across a number of back-office and risk management siloes: treasury owns the capital adequacy calculation. Trading pays for its balance sheet usage. Credit sets lines against individual counterparties. The documentation unit negotiates the contracts that give effect to the credit department’s policies. The legal department reviews and interprets the opinions. Each of them will see the overall problem — the “netting problem” writ large — as somebody else’s.

A “Somebody Else’s Problem” field, or ““S.E.P.”, is a cheap, easy, and staggeringly useful way of safely protecting something from unwanted eyes. It can run almost indefinitely on a torch battery, because it utilises a person’s natural tendency to ignore things they don’t easily accept. Any object around which an S.E.P. is applied will cease to be noticed, because any problems one may have understanding it (and therefore accepting its existence) become somebody else’s. An object becomes not so much invisible as unnoticed.”

The internal costs of the netting problem are similarly spread: industry association memberships are managed centrally and at an unfeasibly senior level. The portion of membership dues that goes on accessing industry association opinions is not broken out. Subscription to netting analytics services may be paid for by legal or credit but recharged to the business. Bespoke opinions are often paid for, somewhat arbitrarily, by the desks that first require them.

The human capital cost of all this busywork — making sure these layers of immortal & invisible protection are in place — is dispersed across various back-office risk teams and recharged to multiple front office trading desks.

The netting problem has no single owner. It is a classic “somebody else’s problem”.

Is it a problem?

The oddest thing about the netting problem is that, in practical fact, it doesn’t seem to be a problem. In the forty-five years since IBM and the World Bank executed that first ever swap, there has not been a well-known case of a receiver in a major financial centre challenging a close-out netting provision, let alone successfully.

To be sure, there have been near misses — famously, a German federal court narrowly construed the scope of contractual close-out in 2016, as chicken lickens like to remind everyone — but even that only threatened to limit and not strike down the single agreement concept. It did not happen. Germany’s regulators immediately amended the insolvency code to validate netting. Given the catastrophic effect such a ruling would have on a country’s own derivatives market, not to mention the stability of the wider financial system, the prospect of such an outcome happening in any other developed jurisdiction and being allowed to stand without corrective geopolitical action is, these days, unthinkable. Close-out netting is not a private commercial preference between counterparties. It is a systemic assumption of stable capital markets.

Naysayers might pick up that I said “developed” jurisdictions. “Aha,” they say, “but what about undeveloped jurisdictions?”

This is not the place to talk in detail about that yet: we’ll get into how banks can practically control that risk later — but note: the effect of designating a jurisdiction “no-net”, as much of sub-Saharan Africa and the Middle East is, is not just to allay the fanciful paranoias of the world’s bank regulators, but it is also to exclude a significant part of the the developing world from the international capital markets. And the international capital markets are exactly the sort of thing that could help them, well, develop.

Still, the received opinion seems to be that Basel rules requiring netting opinions are the very thing that has, single-handedly, spared the global financial system from the mendacious interventions of hostile receivers in far-flung places. Since you can’t presently trade swaps in Eritrea, we have been spared a live-fire experiment in the damage its insolvency regime could to the the banking system. That is why no-one has seen an Eritrean receiver pulling apart a master netting agreement. Maybe. But by the same token, no-one has ever seen elephants hiding upside-down in custard, either.

In the meantime, social justice warriors: if you really want to change the world, here is something to lobby about right away. Not glamorous, not interesting, not half as fun as painting yourself orange and gluing yourself to the floor, but it is important. Campaign against netting opinions!

Solving the problem

Q: How many therapists does it take the change a light-bulb?

The wounded pigeon flapping about in JC’s head was a technological solution to this sorry state of affairs. It is still somewhat complicated, and still involves lots of legal opinions, and it is true there are several even easier solutions — such as just doing away with the regulatory requirement altogether, or having the Basel Committee centralise and promulgate the netting requirements themselves, since they are the ones insisting on the requirement — but since none of these solutions are likely to happen in my lifetime, I invoke serenity’s prayer and present my one, that might.

The concept behind it is simple, but it requires three things to come together.

First, some fairly sophisticated — but not, in 2026, particularly revolutionary or even difficult — technology.

Second, a good understanding of how close-out netting works, the capital adequacy issue it addresses, how rogue insolvency administrators might upset it, what regulators expect to prevent that, how banks practically address that issue, how lawyers think about that issue, why the two don’t very well match, and how, with more thoughtful deployment of technology and a bit more assertiveness with the lawyers, the network might solve some of these problems. This bit I thought I could work my way through.

Third, people in the industry — financial institutions, industry associations, law firms, and their respective decision-makers and operations staff — would have to buy into this new way of doing things. They would have to be prepared to look differently at the world to see the opportunity presented by fixing this problem. The industry “light-bulb” — and all its little siloes, fiefdoms and power bases — would really have to want to change.

Experience tells me that, as a rule, those commanding prevailing siloes, fiefdoms and power bases do not want anything to change. Why would they?

The key, I think, is to find some participants in the system who do not have siloes, fiefdoms or power bases, but who would perhaps quite like them, and give those participants an opportunity to change. If those people embrace change, they can put the rest of the system into such a discombobulated funk that the rest of its citizens — including those with siloes, fiefdoms or power bases — might feel no choice but to change too.

In that case, to hell with the fiefdoms.

Getting to work

In 2026, the first step is manageable. So is the second. As with all complex systems, the third one’s the charm. If those in the “netting industry” even see it as a problem, rather that just a consequence of their professional calling, they see it as an insoluble one, that will occupy them profitably, if not excitingly, for the rest of their career. To be a successful financial markets professional you must have an unusually high boredom threshold, so we should not be surprised about this.

This situational tolerance for pain explains how the present arrangement has settled down the way it has. Not because it best suits the regulatory goal — it doesn’t — but because it suits the interests of those embedded in the current melée. Principally, lawyers. (JC has a theory that the financial markets in their entirety can be seen as a kind of extended phenotype for big law, but that is a topic for another day).

I want to talk about how we might induce the lightbulb to want to change a bit later on: for now, let’s carry on with the overview. It brings together many of JC’s favourite subjects: systems theory, financial engineering, market history and mythology and legal practice management.

I’ve had a bash at writing this as a conventional newsletter, but it just wasn’t working. I missed a couple of deadlines trying to make it work, so I’m going to try to make this into a customised podcast designed from the ground up as an immersive audio experience. That way I can give full flight to my whims for pastiche, fantasy and outright fabrication — if this makes it more fun for me, it should make it more fun for you — and tell the story in multiple parts.

This introductory episode is designed to set the scene, and outline the forthcoming episodes, culminating in the JC’s own live-fire experiment in trying to disrupt this great military industrial complex, an experiment that is doomed to fail.

If it fails, let it at least be an entertaining calamity. If it succeeds, so much the better, and we can save the world, emancipate the enslavèd hordes of inhouse lawyers around the planet and conclude this podcast from my new superyacht in the Mediterranean. I hear it’s nice of the north coast of Sicily at this time of year.4

So remember, when you’re feeling very small and insecure—
How amazingly unlikely is your birth.
And pray that there’s intelligent life
Somewhere up in space, because
There’s bugger all down here on Earth.

— Galaxy Song, Monty Python’s Meaning of Life, 1983

This piece started out as a book review, of Professor Brian Klaas’ recent book Fluke: Chance, Chaos and Why Everything We Do Matters. It quickly would up as a rumination on a much, much bigger topic for which Fluke, is really only the occasion, not the subject, for it sets off one of the many bees in the JC bonnet.

The bee in question is the presently fashionable world-view among tech-bros and people who spend too much time online that everything can be computed. This “computationalist” outlook, and its best practical example, the omnipresent Turing machine, has wormed its way into contemporary intellectual life and is at risk of getting stuck there. This, I think, would be a tremendous pity.

The computationalist view runs more or less as follows:

1. Turing machines are, by design, deterministic.

2. You can model the human brain as a Turing machine.

3. Therefore, the brain is a Turing machine.

4. Therefore, the human brain is deterministic.

5. Therefore, human agency is an illusion.

Professor Klaas himself is a good case study, because much of his book is wise and — excuse the pun — enlightening, but he still winds up mistaking the map for the territory and concluding that since we can be made to seem like machines, we are machines, and are therefore constrained as machines.

This seems like a typically dusty academic debate, but it has real-world implications for not just the hypothetical freedoms of metaphysical will, but the real-world freedoms of thought and action. Where you stand on this question makes a political and cultural difference to how you feel about where other people should be allowed to stand on it. We will turn to that at the end.

A big “but”

I have been grappling for some time with what is so troubling about the modern techno synthesis — End of History millenarianism, truth, data modernism, determinism and the oddly illiberal fix these logical ideas put us in — but have struggled to put my finger on it.

In Fluke: Chance, Chaos and Why Everything We Do Matters, “disillusioned social scientist” Brian Klaas helps. But not as he means to.

This is a silly book. It makes a great show of being interesting, but then steers off a cliff in its final chapter, which presents as a big “but”. As G.R.R. Martin puts it, “Everything before the word ‘but’ is horseshit.”

You might think I am being unfair or uninformed in my opinion, and so I might — it would hardly be the first or last time — but even Professor Klaas would have to admit it is not my fault: I can hardly do otherwise. It is written in the stars.

So, you shouldn’t blame me, but if you do that’s not your fault, either: that too, is written in the stars. Indeed, Professor Klaas would oblige himself to concede, as he asks us to, that all of creation — all its galaxies and nebulae, all its tragedy and comedy, its infinite majesty and infinitesimal frippery exactly as it appears, right down to this silly article about that silly book — has been coming, unerringly and ineluctably, since the dawn of cosmic time itself.

Which means I have an excuse — nay, a compulsion — to talk about metaphysics.

God, mind and free will

“And if we are to prevent the lights going out on our lives once more, we should ask ourselves crucial questions.

Where are we? How did we get here? Why did we come? Where do we want to go? How do we want to get to where we want to go? How far do we have to go before we get to where we want to be? How would we know where we were when we got there?

Have we got a map?”

—Rowan Atkinson & Richard Curtis, Marcus Browning MP, 1980

Anyone with a tertiary education who didn’t take at least one philosophy course missed the point of the exercise. The sine qua non of the university experience is, surely, stage one metaphysics. Its three great questions — how did we get here, how does consciousness work, and do we have free will? — are not a million miles away from those posed by the hon. Marcus Browning.

“God” and “mind” really collapse into “free will”, and that boils down to how you feel about the causal principle: has every action in the cosmos a complete and identifiable set of reliable mechanical causes, or is the universe some how unpredictable, biddable and capricious?

Those who embrace the causal principle are broadly classed as “determinist”. Since, given enough information, one can precisely calculate the outcome of any interaction between any objects in the universe, the interaction of composite objects must be a function of their components.

Since classical mechanics assumes that, besides elementary particles, all objects are composites it follows that the behaviour of everything can be reduced to the behaviour its components. It is not quite turtles all the way down, though: it stops at these subatomic particles. Their behaviour, theoretically, can be traced back to the singularity whence we, and the whole of creation, came. There is, therefore, nothing new under the sun. All was inevitable, Q.E.D.

If this is right, certain popular beliefs about the cosmos cannot be true. There cannot be a non-material interventionist God: if there were, some events would not have a material cause. Humans cannot have free will: all human actions are the product of traceable electrochemical impulses in the brain.

While much of the West has acclimatised to the first idea, the second one is taking some getting used to.

If this all seems a bit desolate, there are a broad range of non-determinist philosophies that might suit you better. Beyond “non-determinist,” these philosophies have no catch-all label. If it would not lead to confusion you might call them “casual” as opposed to “causal”.

They include most types of mysticism and religion and any belief in magic or the occult. They also take in the widely traduced “continental” philosophies of relativism and postmodernism, but also some “rationalist” parts of the intellectual landscape: classical economics, much of behavioural and social science, systems theory, chaos theory and — though it might horrify Professor Dawkins to acknowledge it — evolutionary biology. These are all pragmatic, “emergent” philosophies that take the world as they find it. While they might find their explanations in granularities, they tend not to extrapolate actual predictions from them.

Science’s insistence on analytical rigour in inferring causal principles from observed regularities, seems an incontestably good and valuable thing: it has vouchsafed flight, sanitation, aqueducts, viticulture and so on. But if we say, as Professor Dawkins does:

“Show me a relativist at 30,000 feet and I’ll show you a hypocrite”.

We throw quite a lot of baby out with the mystical bathwater. Like the idea we can have free will.

So we are at a bit of an impasse. To enlightened liberals — often the same people as the modern rationalists — free will is also a generally good and valuable thing. All modern polities — not to mention all the ancient ones — depend on it for their basic coherence as social structures.

There is no room for any immaterial agency inside a human that can override the eternal logic of cause and effect. To act a propos nothing but “animal spirit” must, at some synaptic level, violate Newton’s laws about conservation of energy.

This is a great paradox: if we have free will, science is falsified. If we do not, the entire premise of civilisation is.

Thus, the “free will versus determinism” debate presents a dilemma that has animated stage one philosophy classes as long as anyone can remember. Every now and then, someone comes along and tries to sort it out for once and all — the late Daniel Dennett spent the last thirty years of his life trying to do so, for the determinists, but — in my mind at any rate — fell a long way short. Contending that freedom of thought and expression is an illusion is a hard sell.

Nor is it one that, in the final analysis, makes a great deal of difference. Either the causal principle is true, or it isn’t, and we could have free will, or none, and it would not make any difference to how we must interact with the universe. Plato had this much right: we have only shadows on the wall of the cave to go by. It doesn’t much matter what causes them.

That is why “God, mind and free will” is only a stage one course: it illustrates philosophy’s gift for paradox and at the same time, its deeply-rooted irrelevance. The debate is titillating but, at the same time, stale: causal principles seem to hold, and we seem to have moral agency, and humankind has managed the theoretical conflict ever since we first looked up at the stars.

The transparently silly answers the paradox throws up suggest it is a silly question. So, for the longest time the scientists and humanities have kept out of each other’s way. But developments on our ways of being occasionally reopen the debate. The alarming advances in “compute” are doing that now: there is a generation of technologists who are once again yearning to solve the universe.

Professor Klaas is here to help them.

The great divide

In modern academic discourse, there are two strands of thought: the icy rationalism of the STEM disciplines and the post-modernist mumbo jumbo of the humanities. This is, of course, an outrageous generalisation, but it also, kind of, isn’t.

Occasionally, shots ring out across the aisle: mendacious physicists fox humourless sociology journals into publishing PoMo-tinged gobbledegook, while philosophers and historians ruffle biologists’ feathers by pointing out that their discipline cannot be as rational as they would have us believe.

For all that, there is buyer’s remorse on either side: a clique of humanities academics, uncomfortable with Post-modernism’s reductio ad absurdum that nothing means anything, have organised themselves into a rationalist stance, huddled around the theory of evolution. Prominent among them are linguist Steven Pinker and late philosopher of mind Daniel Dennett but their high priest — if you’ll forgive the expression — is biologist Richard Dawkins. This group is outspoken in its criticism of religion, relativism and other ostensibly magical accounts of human ingenuity.

You may wonder, as I do, whether there isn’t something ironic about this, given the contingency of “Darwin’s dangerous idea”. As Professor Dawkins explains it, the evolutionary process takes us away from an imperfect now; it does not converge upon a perfect later.

It was Professor Dennett who did the most to integrate evolutionary concepts into the humanities, sheeting them back to information theory by means of that algorithm — the “universal acid” that explains everything. Evolution is profoundly algorithmic — that is Darwin’s Dangerous Idea, in a nutshell — and so, of course, are computers: Turing machines. So if this is how evolution works, and this is how computers work, why not brains?

At the other end of the STEM spectrum, information theorists and cyberneticists strive to apply their inorganic learnings to human systems. They work backwards towards the meatware, noting the calculable “Shannon entropy” of the symbol strings by which humans communicate. Cybernetics is a positivist sort of systems theory that strives to solve things from the middle — to solve the management conundrum — but there are better forms of systems theory that start at the edges of the network, with agents and their immediate interests, and let the middle of the system look after itself. See the end-to-end principle.

Now, computation is a bounded, mathematical, calculable, zero-sum endeavour. It is fully causal. It is intensely deterministic. Therein lies the rugged beauty of the Turing machine: fast, cheap and utterly predictable. It doesn’t make mistakes. It doesn’t pick up the wrong end of the stick. It can’t. It is obliged to follow a determined causal chain of reactions. All steps can be reverse-engineered. This makes it quite a neat nomological machine.

This compels a worldview where everything is directly, bi-directionally causal: assuming a given operation, a machine state N’ can be computed by reference to machine state N that preceded it, and vice versa. One can journey up and down this chain of reactions indefinitely without losing fidelity or risking a different outcome.

It would be great — some think — if we could quantise and optimise human intelligence the way we optimise computing. But while we understand pretty well how Turing machines work1 we don’t, very well, understand how brains do. In particular, we don’t understand how consciousness works. We don’t know what it is. We don’t even know if it is.

Professor Dennett was not the first to see in Turing machines a framework for understanding human consciousness, but he pushed the idea harder and more successfully that anyone before him.

But this is not so much to anthropomorphise machines as to robomorphise humans. For a Turing machine is a weak metaphor for human intelligence. Turing machines are not like humans: as George Gilder drily noted, that is why we build them.2 Humans are inconstant, slow, easily bored and they take up space. They are hopeless in the environments in which machines excel. But in the chaotic, unbounded, inchoate complex environments in which humans excel, machines — even generative AI — are hopeless. It is precisely human flexibility, imagination — our freedom from causal constraints that gives us this edge. Humans can imagine. Machines cannot.

There is a flip side: as a result, humans are inconstant. They can “misinterpret”. They can pick up the wrong end of the stick.

Fluke

This is the category error Professor Klaas makes in the last part of his book, having made a great show of avoiding it in the first three quarters. There is much to agree with in his groundwork — he talks perceptively about the pervasive contingency of complex systems, but it turns out that he has deliberately taken up what he must regard as the wrong end of the stick to make a point. Because all computer operations are provably causal — garbage in, garbage out — and because computers superficially resemble brains, the temptation is to infer that humans are unavoidably causal too. This Oolon Colluphid-style “puff of logic” prioritises causality. It rules out God, the mischievous supernatural and all those big-shirted French post-structuralists — but jettisons the principle of free will, too.

Hence, if true, the inevitability, from the Big Bang, of this review. I had no choice but to read Professor Klaas’s book, and no choice but to be exasperated by it. If there is a God, she is mendacious indeed. But she is also as pointless as the universe she has created.

Though the universe seems disinclined to random irregularities — it conforms, after a fashion,3 to our cosmological models — our sample size is minuscule in a spacetime of incomprehensible proportions. The data upon which we found our assumptions of universal causation is, for all intents, nil. And it is vulnerable to our own evolutionarily-conditioned selection bias. What we see is all there is. We have evolved to truck in regularities. Ostensible irregularities we suppose, without evidence, can be explained by as yet undetected causes.4 But even that is a contingency.

So, this is all a bit wishful — for those who don’t find it utterly desolate.

Still, Fluke starts off brightly. There is good discussion of path dependence, contingency and convergence. Our existence here is the product of a colossal sequence of flukes. Things would not have had to be very different at any point in our evolution for us not to be here at all.

For such a glib observation, Professor Klaas hammers it hard. Before long, we see why. He turns to chaos theory and invokes the familiar metaphor of Amazonian butterflies. But the lesson of chaos theory is not that “a butterfly’s wing-flap caused the Ottoman Empire to collapse”, but that for all we know a butterfly’s wingflap could have.

That is illustrated by the marvellous contingencies Klaas illustrates — but he is looking out his rear window at them, as he drives away, by which stage, they are no longer contingencies. They are crystallised histories. They are no longer emblematic of chaos. They are now — to the extent they were recorded at all — fixed historical data. The contingent process — our observation of these data — is complete. What remains can be represented, without much loss, as a string of symbols. It is but a single path between two points in a garden not just of forking paths, but infinite, random, interconnections. To choose one path is to forgo all the others. This is the opportunity cost of existence.

The string of symbols we are left with have no meaning until we run our information processing apparatus over them. It matches against familiar patterns and creates a narrative. In this way our symbol strings produce meaning. This is not a binary, Turing-style symbol-processing operation, but an imaginative one. It, too, is contingent, a willed extraction of one meaning from a vast plurality of possibilities. We fox ourselves that the story we chose is the “true” one. That is the pattern we draw on the side of the Texan barn. But we are not Turing machines. It is not inevitable until it is made.

At least with history there are data. We have at least something to draw our fancy casual chains over and declare sacred and “true”. This is not true of the future. Here our uncertainty is “aleatory” — it has not happened, so we cannot know it — and not merely “epistemic” — it has happened, unobserved, so we don’t know it.

In a complex adaptive system filled with intentional agents, building that narrative and generating consensus about what has already happened is hard enough. Predicting what will happen next is much harder and, as the horizon recedes, quickly becomes hopeless. Complex adaptive systems adapt. They have autonomy. Intentional agents intend. They have agency. Pretending they are mechanical ducks for the sake of a commitment to causation gets us nowhere.

Professor Klaas even states this, outright: he cites a neat experiment in which social scientists were presented with sets of historical input data about human subjects and asked, based on their own published theories, to predict behavioural outcomes. They were, of course, systematically unable to get anything right. Physical scientists laugh up their sleeves at social science, but the outcome would be no better were you to ask a biologist, in a double-blind test, to predict the present form of juramaia sinensis, a tiny, nocturnal, insectivore from the Jurassic era.5 And nor would the mechanical physicists do any better. We are not puzzled that professors of ballistical mechanics are no better at cricket than anyone else.6

Here we must be careful not to make another category error. There is, thereby, little practical difference between “unknown events in the past” — epistemic uncertainties — and “unknowable events in the future” — aleatory uncertainties. But — and this is rather the point — there are different things to take from that similarity. Professor Klaas proves it by drawing an opposite conclusion to the one I would have: rather than taking it to illustrate how unreliable historical data is, he takes it to show that the future that is no less set in stone than the past.

At this late stage Professor Klaas declares, as might a newly-minted philosophy undergraduate, that there are two alternatives: either the causal principle holds, the cosmos flies by calculable wire, and the reason we can’t better predict it is due to our own inadequacy and lack of suitable data, or there is free will, science is worthless and the universe is random.

Doing without causation seems unthinkable, and the cosmos appears to be ordered and science seems to be worthwhile, so Professor Klaas, with more exhilaration and less regret than I would, embraces causality and gives free will the old heave-ho.

The thing is, on their face, both are plainly preposterous positions. Professor Klaas has boxed himself in with a silly stage one a priori thought experiment.

Given that he calls his blog “the garden of forking paths” — named for a Borges short story— seems to be all about contingency and unpredictability of complex systems, so it is a bit baffling that Professor Klaas still concludes that everything is pre-ordained.

Since, even if so, we have no practical ability to predict what will happen, and we seem to have autonomy, and in any case there is no way of knowing, then what do we achieve by saying “well, it is all predetermined”. How does that even help us?

The computationalist view, the infinite, and the end of political freedom

“It wasn’t infinity, in fact. Infinity itself looks flat and uninteresting. Looking up into the night sky is looking into infinity — distance is incomprehensible and therefore meaningless. The chamber into which the aircar emerged was anything but infinite, it was just very, very, very big, so big, that it gave the impression of infinity far better than infinity itself.”

—Douglas Adams, The Hitch-Hiker’s Guide to the Galaxy

The question is not without its practical consequences. In one sense it is a desolate view, hankering to get to the end to the journey we define ourselves by being on: life. The computationalist view offers the same desolate resolution as do the Abrahamic religions: an end state, where everything is solved, everything is managed, a benevolent higher intelligence silently ensures everything is optimised, and no-one wants for anything. Religions promise that in an afterlife: computational techbros promise it here, if not now, then in the foreseeable future. But a universe without problems to be solved, lots to be improved or games to be played — with no riddles, mysteries or hazards — of unlimited accommodation is hell as much as it is heaven. Utopia and dystopia are the same. No-one would like such a world, and we can already see what happens when we approach it: people wilfully ruin it.

Francis Fukuyama — he has had some bad press, including from me — captured it well:

Experience suggests that if men cannot struggle on behalf of a just cause because that just cause was victorious in an earlier generation, then they will struggle against the just cause. They will struggle for the sake of struggle. They will struggle, in other words, out of a certain boredom: for they cannot imagine living in a world without struggle. And if the greater part of the world in which they live is characterised by peaceful and prosperous liberal democracy, then they will struggle against that peace and prosperity, and against democracy.7

Heaven would be awful. The Devil has all the best tunes.

But there’s a more insidious implication, too. A causal, solvable universe implies a single truth. It means those who have that truth are justified in suppressing anyone who promotes a different idea. Scientism leads to this: we see harmless forms of it in Richard Dawkins’ grumpy (and uninformed) tracts against religion. Elsewhere, the religious are just as guilty of the same kind of intellectual imperialism.

But, either way, it is an illiberal instinct: to assert a single solution — let alone to enact it — is to stop people from living their lives as they would choose. Citizens should be free to make their own mistakes: who knows? We might all learn from them. Preventing it might deprive us of the serendipities that have characterised scientific discovery over centuries. In any case we should not wish ourselves to a utopian endpoint that none of us would like much if we got there. We are not non-player characters. We are not hopeless invalids better hooked up to a pleasure machine for our own wellbeing. We do not want to spend an eternity making small-talk with do-gooders. We came here to struggle and make sense of things.

I’ve wittered on enough and have to finish this now to get out the door to a talk by Iain McGilchrist, whose marvellous book The Master and his Emissary gives a much more hopeful perspective on this very question.

See also

• Robomorphism

• The Master and his Emissary

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Here are parts 1 and 2. For those who can’t be bothered to read parts 1 and 2, but still want to read part 3 — I mean, suit yourself — or who have read them but just forgot, here is a recap.

Recap

We started with the simple question — simple for securities lawyers and ISDA ninjas, that is: it might not occur to anyone else — “why do Americans prefer collateral pledges and Brits prefer title transfer collateral?”. In part 1 we covered the difference, in the JC’s argot, between “collateral” and “security”: “collateral” is something you hand over to your creditor. “Security” is an enforceable legal priority you grant over assets you do not hand over. These are quite different modes of performance assurance, especially when it comes to managing a creditor’s “cost of funding” indebtedness it is owed.

We are accustomed to thinking mainly about credit risk — lawyers are prone to catastrophising and never looking on the bright side — so in Part 1 we spoke a bit about a happier reason for taking collateral: funding optimisation. In other words, making more money.

In part 2 we will traced a “just so” history of financial collateral from no collateral or credit mitigation, to merchants knocking about on the high seas and off the Barbary coast — we spoke a bit about poor old Shylock in the Merchant of Venice — to customary liens and pawnbroking arrangements — this was all the excuse I needed to tell an amusing story about Jimi Hendrix, and I may well come back to it — and fetched up with an exposition on the development from the 19th century of modern financial markets — negotiable bonds, stocks, centralised markets with oddly gesticulating men in silly blazers and ladies scribbling things on blackboards — to electronic markets, clearing, custody, and the opportunity these modern collateral arrangements presented to lenders to better manage their funding costs. That is, make money.

We ended with an odd question: if borrowers were providing more moneys’ worth in collateral than the actual money they raised, could creditors use that collateral somehow to offset their funding costs of the very loan the borrower used to buy the collateral and did that mean, in a round about way, that borrowers were, in effect, lending to themselves?

In this part we will alight on the answer which, at the risk of spoiling it, we will discover to be Yes.

That is weird enough but we will see that, thanks to some odd wormhole or eddy in the flow of spacetime, this means a bunch of different financial instruments, that seem quite different from each other, seem to collapse down to a single wave form, and become the same.

We will compare collateral arrangements with the financial transactions they collateralise and see how —if viewed in purely economic terms — they are not really that different. Things get a bit strange loopy.

So, without out further ado, let’s play the third act of this odd movie.

The hidden financing in every swap

“What is dull is never done.”

—The Swappist Oath

But hang on, if a swap is a “self-funding” loan then, by ponying up collateral, isn’t the “borrower” lending to itself?

The answer is, in a sense, yes. But that is the very distinction between “borrowing” and “financing”.

Borrowing is the outright transfer of capital. The lender gives money, outright, and accepts the borrower’s unadorned credit risk for its return.

Financing is the temporary conversion of an existing asset into cash. You give the asset away in return for cash, against a promise to repay the cash against return of the asset. It is a “swap”, of sorts, even if not quite in the sense implied in an ISDA.

The financier’s risk is different: it has intraday exposure not to its financing counterparty, but to the financed asset. This usually has a greater value than the sum advanced: as much as 30% more. Only if the asset suddenly collapses in value — if it “gaps down,” in the vernacular — does the financier have any credit risk to its financing counterparty for repayment.

The financier, in the vernacular again, has “second-loss” risk to its counterparty.

So, to labour the point:

Lending is the outright, uncollateralised transfer or money from lender to borrower.1

Financing is the temporary, and reversible, exchange of an asset for its cash value.

From one angle only — that of “an advance of money from one party to the other” — do they look the same. In the round, economically, they are quite different.

It is a fun exercise to bucket different financial products into loans and financings:

A swap as a financing

The mark-to market exposure under a ISDA Master Agreement, not counting its CSA, represents outright indebtedness. Not necessarily to the dealer: the indebtedness — the “Exposure” — can swing in and out of the money. In an odd way, a Swap portfolio resembles a revolving credit facility — an overdraft. The only difference — and it is structural and not economic — is that the “withdrawals” and “deposits” in a swap are beyond the control of debtor and creditor. They are generated by — they are “derivatives” of — market movements on transactions.

But swaps were not designed to be like overdrafts. They are meant to be “unfunded” instruments. They were designed, by the First Men at the dawn of the Age of Swaps, as paired, offsetting loans, the principal sums of which are meant cancel each other out. What is left is, literally, a “derivative” of the exchanged loans: the present value of remaining cashflows under one loan deducted from the present value of the remaining cashflows under the other. This is a neat expression of the market delta.

Since swap dealers are not meant to be borrowers nor lenders, and don’t take deposits to fund their operation they are not necessarily regulated or capitalised to take large debt exposures to their customers. It would be eye-wateringly expensive to do so even if they were.

So, dealers require the their swap exposures to be transformed from loans to financings that do not attract the same capital charges.

A CSA is designed to solve that problem. Economically it is the inverse of a portfolio of swaps. So, if a swap is an overdraft facility, so is a CSA: only its equal and opposite. Both are outright disposals of capital.

Of course, a CSA can only exist with an ISDA. A CSA existing independently is a nonsense. CSAs are sort of “ISDA-linked swaps”. Their “underlier” is the net Exposureof the very ISDA they are collateralising.

When we add a CSA to counteract an ISDA Exposure they cancel each other out: Exposure goes one way, variation margin goes the other, and — hey presto — there is no longer an outright disposal of capital. We have a financing.

Usually, a financing starts with a party putting up an asset to raise money. In a margined ISDA, that sequence is reversed — the dealer “lends” money, and the customer punts over an asset to collateralise it, and that makes it into a financing — but economically, they are the same, whichever comes first.

From this perspective, a swap looks like a margin loan from a dealer to a customer to buy a financial asset. Instead of giving money to the customer to buy an asset, the dealer uses it to buy the asset as a hedge, for its own account. The dealer now owns the asset, but pays away all the its economics to the customer.

It also looks a repo, which looks like a stock loan, which looks like PBr. Are all just different articulations of the same principle. Financing.

I feel like I have been labouring this point. Time to move on.

The financing parcel game

Triago: All the world’s a margin loan —
Each man a mere financier:
Who calls out wonkish marks and
Pledgès troth o’er something fancier
Whate’er fetches up
And passeth thy criteria
Rehypothecate the lot, dear friend—
In a flush of rehysteria.

—Otto Büchstein, Die Schweizer Heulsuse

Recall that what an outright lender cares about is making sure its cost of providing capital — the cash it has to stump up to make the loan — is less than the return it gets from lending it. Borrow cheap, lend expensive.

(Seems trite, I know, but does not seem to have occurred to the treasury department at Silicon Valley Bank.)

Generally, a bank funds its loan book by borrowing, from retail depositors, commercial paper, medium term notes, bonds raised in the debt markets — and repos — but that is to give away the punchline a bit so let’s park that.

The bank must pay interest on, and hold capital against, those “funding liabilities”. The difference between the amount of interest a bank can earn from lending money, and the amount it must pay to acquire that money, is its profit margin.

A bank that could find a way of lending money to X without first having to borrow it from Y would be in a rather special place. A place that would seem, rather, to transgress the laws of banking physics: how can you lend something you do not first have?

Like this. Step one: take financial collateral from your borrower thereby converting an outright loan into a financing. Step two: convert that financial collateral into money, and repay your lenders with the proceeds.

Behold: the beguiling magic of a margin loan.

By financing — that is, converting into money — the collateral it received from its borrower, a margin lender no longer needs to borrow the money it used to make the margin loan. The margin borrower is, effectively lending to itself through its collateral.

Selling the collateral outright would leave the lender with unhedged market risk to that collateral — it needs to return it the borrower later so if the price goes up after it sells it, it will book a loss — so the lender needs finances the collateral with repo or stock loan arrangements. As long as its repo counterparty is there, it is hedged against collateral price risk. Any margin arrangements on its repo will mirror the margin arrangements on its own margin loan. Economically, the margin lender steps out of the picture. Unless there is a disaster.2

But hold on: how can you sell my asset —?

This is all well and good, but hold on: how are you meant to sell an asset that has only been pledged to you, and that therefore you don’t own? This is exactly the problem of the pawnbroker we saw in the last episode: unlike a right-handed guitar, strung upside down for a left-handed m****g genius, when the pledged asset is fungible financial collateral, the lender can sell, loan, or re-pledge it. This process is called rehypothecation — if you are American — or “reuse” if you are a Brit.

So we should talk a little about rehypothecation.

The first time you encounter it, it will seem utterly mad. This because, candidly, it is utterly mad. It is one reason why the British view of collateralisation, by title transfer, makes more sense than the American view that collateral should be transferred by pledge.

It is a piece of American conjury, designed to overcome the difficult fact when you provide collateral by pledge you give up possession, but not ownership. You grant a lien over an asset that remains yours.

This is rather like a pawnbroking arrangement: when Private James M. Hendrix of the 101st Airborne pitched up with his right-handed Stratocaster, strung upside down for left-handed m——g genius, his pawnbroker lent against the guitar and had good credit protection if Private Hendrix failed to return, but until he was obliged to, the pawnbroker had to sit on the Stratocaster. It could not sell it, pledge it, or raise money against it.

That buggers up the opportunity for funding optimisation. So some bright spark contrived a pledgee’s right to “rehypothecate” a pledged financial asset: this is the right to sell it, on condition that you are liable to buy it back whenever its owner wants it back. This is conceptually possible because of the unique nature of modern financial instruments: they are inherently fungible — individual securities of the same ISIN can’t vary in quality — and in the modern era, being mere electronic impulses in a digital menagerie they don’t really have individual corporeal identity at all — and lastly, the market is liquid, meaning securities can, in most cases, be readily acquired. The only variable is price, and that is an explicit risk the rehypothecator runs.

In the real world of real, perishable, scuffable, dentable, string-it-upside-down-for-a-left-handed-m——g-genius-able assets this would not be possible. Each asset is unique. Its nature and value are coloured by the unique path it takes through spacetime and the vicissitudes it encounters along the way.

None of that matters for financial instruments. They are abstract concepts. They can’t perish, be scuffed, dented or strung upside down for left-handed m——g genius. So the idea of rehypothecation makes a smidgen of practical sense. A scintilla. A wafer-thin-mint of sense. But no more. It works, as long as you don’t think too hard about what, in theory, it means.

A rehypothecated asset might as well have been title-transferred. To all intents and purposes, it has been. Rehypothecation converts a pledge into an outright title transfer, only with annoying formal, and quite moot, perfections and legal ninjery surrounding it.

British and American means of posting collateral are, to all practical intents, the same. You title transfer to the dealer, the dealer punts it out into the market to raise money against it. This it uses to repay its own treasury department, from whom it borrowed the money to buy the hedge in the first place. You don’t owe the asset. You have a claim against the dealer for an equivalent asset.

Is everything a financing then?

The implications may take a while to sink in. A margin lender is, basically mirroring its customer. It rehypothecates posted collateral into the market. More than likely, the lender’s market counterparty will do the same thing. There unfolds a chain of back-to-back financings. The collateral assets fly around the financial markets, like neurons in a brain. Rather the way cash flies around the economy. The greater the velocity, the more productive everything is.

Could this sort of thing happen indefinitely? Yes.

Does it? Yes.

Who knows where it all ends up? Search me.

Much of modern finance is an elaborate chain of, effectively, margin financing arrangements. This is a weird and confronting idea when you first encounter it.

But it explains a lot.

For there are pawnbrokers and mechanics, and then there are twenty-first century multinational financial institutions.

As markets evolved from enterprising men on bicycles discounting jewellers’ bills in lower Manhattan, and as money, credit and systems digitised, capital efficiency has become ever more imperative. As markets grew, crashed and recovered, so did regulations. Each crisis begat new rules; each new rule focused more intently on capital regulation.

As the computerised market sped up, so too did the regulatory response. There is a curious, ironic feedback loop, where technology enables greater complication, which enables more risk-taking, which triggers collapses, which triggers regulation, which triggers innovation in means of optimising capital efficiency, which enables more risk-taking — you can see where this is going. Basel I was 30 pages. Basel 3 runs to several hundred.

All of this momentum pushed financial institutions to the same place: capital is expensive, balance sheet is precious, and assets must therefore be put to work. There’s some irony here. Regulations designed to reduce systemic risk incentivised institutions to take it: to sweat every last drop of funding from their operations — which only increased the speed and rate of flow. No longer would yards and yards of customer assets be left to sit quietly in dusty custody accounts, any more than customer cash is left to sit in a safe.3

Everything that could be reused to raise cash would be. Longer, less visible financing chains emerged. Participants grew ever more interconnected. There was greater complexity. Assets circulated with ever-greater velocity.

Has this reduced systemic risk? Or simply shifted it? Great question. It gets answered in real time.

See also

• Variation margin: deep history part 1

• Variation margin: deep history part 2

• A swap as a loan

“I once got all the way from Glasgow to Edinburgh without a ticket. I walked.”

— Sid Snot, The Kenny Everett Video Show.1

“There are more network use-cases in heav’n and earth, Horatio, than are dream’t of in your philosophy.”

— Shakespeare, Spamlet I, vi

An iron-fisted Romanian

“The Bickerings,” ancestral home of the Contrarian clan, is freezing old pile in Squatney Green. It is cold enough, but made worse on account of the JC’s missus, the Contesă Birgită von Sachsen Rämmerstein, who controls the central heating with an iron fist.

The Contesă grew up in a stone castle in the high Transfăgărășan, her father was a tyrant and she has therefore grown accustomed to a chilly ambience. The family was grand but impecunious, and she habitually regards any attempt to put temperatures into double figures as evidence of immutable moral decay. “Eef you are cold,” she is fond of saying, “you should put on a hat.”

I am, by these standards, weak. I am often tempted into defiance when she is not looking. Until now my meagre resistance has been mainly useless: the Contesă is gimlet-eyed, and immeasurably helped by our central heating system which was designed about the time they built the computers for the Apollo programme, and it has similar functionality. While it can, I am told, schedule and regulate temperatures this requires an advanced facility with algebra that I, alas, do not have.

Nor will the Contesă countenance my occasional suggestions that we upgrade to a modern central heating system with an intuitive user interface. That would involve massive expenditure and, besides, capitulate to my lack of Transylvanian fibre.

But recently things have changed. I have identified a way of fitting inexpensive replacement valves on our radiators. They are wifi-enabled and fitted with a smart thermostat. They can be programmed, controlled and adjusted from an app.

I used the meagre allowance the Contesă grants me and bought a set of smart valves. As the northern hemisphere winter grinds its saturated way to a squelchy close, retailers are trying to shift their inventory before the spring arrives, the world warms up and it is too late. The valves are currently on sale. I bought seven and I got a bargain: they were half price.

The problem with central heating systems

Until there was the internet, the problem with upgrading a traditional central heating system was exactly that: it is a centralised system. It has a heavy structure. There is a single central brain, a designed-in “nervous system” and it is integrated and not articulated: if you want to upgrade any part, you need to upgrade the lot.

The brain controls two systems: a water system, that sends hot water from the boiler out to spur radiators around the house, and an electrical system that measures temperatures around the house with remote thermostats and sends that information back to brain. The brain has a “preferred setting” from which it controls how much water it should send out to the radiators. If the thermostats say, “it is too hot” the central system shuts off. If they say, “it is too cold” the central system opens up. There is no great intelligence in the system: it has some kind of a time scheduling function and a temperature gauge, and that is it. More sophisticated systems divided the house into temperature zones, each controlled by a single thermostat.

But beyond that, to micro-manage their local environment, users would have to manually adjust the radiators. Each has its own analog thermostatic valve connected to a switch that gates the pipes running into the heater. If it opens, water flows in. If it closes, water stops. But the manual valves are not connected to the central brain: if a radiator’s local valve is fully off, the radiator will not come on, whatever the central system tells it. The electronic thermostats that talk to the central system’s brain are overriden by the manual ones that do not. On the other hand, if the central system thinks the zone is too hot, it won’t send any water to the radiators, so it won’t matter how the local radiator valves are set.

The system is, therefore, something like a binary logic gate: a radiator heats only if both the electronic and the manual valves open. It is what lawyers, and grammarians, would call conjunctive: an “and,” not an “or”.

It all takes quite a lot of — well — plumbing and wiring to install such a system, and therefore quite a lot of disruption if you want to replace it. The electronic thermostats are hardware-controlled and connected by cable, chased into the walls of the house. God forbid should I suggest we move a thermostat and upset the Contesă’s Farrar & Ball™ elephant spunk™ skim coat wall finish.

Since our control panels were designed in the late 60s, they have little of the functionality we are used to these days. They were not designed to be upgraded. They are not modular. Their programming is hard-coded into ugly little devices dotted around the house. Not just ugly, but dysfunctional: they hail from a time before “user experience” was any kind design criteria. There are four buttons, embossed with hieroglyphics I don’t understand, and a small liquid crystal display panel that displays different hieroglyphics that I don’t understand either.

It isn’t clear what any of them do. How we originally programmed them is now lost to posterity, and for some years now we have just tolerated the meagre assistance they provide in the depths of winter. For the Contesă, this is business as usual. Over the years I have invested in knitwear. The heating comes on when it deigns to come on, goes off when it deigns to go off and that is that. The Contesă and I shuffle around our frigid house, wrapped up in mittens and scarves.

The problem is solvable because of the ingenious design of the valves. They accord with a principle of network design called the “end-to-end principle”. It is quite unintuitive but, when you get your head around it, utterly brilliant. The design of the internet is fastidiously based on the end-to-end principle.

But — and this is the beautiful thing about design — the internet’s construction in the 1960s long preceded theory that made it viable. The end-to-end principle explaining why the internet works was not identified or formalised until 1984.2

How to design networks

When creating a network of dispersed “users” — call them “endpoints” and the system a “distributed network” — you have design choices to make. Different network designs have different pros and cons and different consequences for scaling, efficiency and task management. It is all rather mathematical.

Direct point-to-point networks

The simplest, in theory, is to link every endpoint in the network directly. We can see this rapidly gets complicated. With a two endpoint network there is one link. Adding a third endpoint, requires two new links. Adding a fourth requires three. The problem grows arithmetically as you add new users. Given a total userbase of N, the number of new connections needed to add a single user is N - 1. The more endpoints, the more links required to add a single new user.

The application for which the network is used is important. If all users will be interacting with all other users all the time, this may be the maximally efficient design. An example of this kind of network is a high-performance computing GPU cluster used for AI training: here the point is parallel processing, where every node exchange data directly with every other node on the “network” (a series of gates on a graphics processor) at maximum speed with minimal latency. But it is a pretty unique case. There aren’t many cases where a point-to-point network is a great design choice.

Most human networks are not like that. We only have a certain amount of personal bandwidth. We can only read one book at a time, or watch one film at a time. Our interaction with a given network is highly selective, and in fact unique: how I experience and interact with London is unique: I go to the Cherry Tree in Ost Finkelstein for my apples. The Contesă goes to an odd little Russian shop to get ingredients for her borscht. She does not need a link to my greengrocer. I don’t need a link to her cabbage purveyor.

In this case a fully-connected network becomes progressively harder to scale and less efficient. The more endpoints in the network, the less likely user is to communicate along a given link. A directly linked network, therefore, contains a great deal of redundancy.

Hub and spoke

Another way of designing networks is a hub and spoke model where local users are connected to a single large hub which has a much greater bandwidth connection to other hubs, to which other local users are connected. This is how, for example, railway networks work: There are a small number of “nodes” — stations — and these have limited set of very-high bandwidth connections between them. Endpoints — passengers — must make their own way to a node. But “adding new users” is therefore, from a “hub and spoke” network’s perspective, a low-cost, low complexity activity. It carries a predictable, low marginal cost. building additional hubs and connectors between them — that is, rails and tunnels — is obviously more expensive, but it is a one-time expenditure that happens infrequently and supports a greater capacity to handle users on the network. It is much, much less wasteful than a point-to-point network.

But hub-and-spoke models have some odd inefficiencies of their own. For one thing, connection routes on the network may be much longer and more complicated than is needed to cross the physical distance between user endpoints in real space. The London Underground is famous for this sort of thing. Visitors who take the journey from Wood Lane, on the Circle Line, to White City, on the Central Line — which takes about three quarters of an hour via Liverpool Street, or over half an hour with two changes, via Notting Hill Gate and Edgware Road —deposits them across the road from where they started.

Furthermore, knocking out a single hub can break the whole network, at least for anyone connected to it, or depending on it for a through link to another person.

The hub-and-spoke model is, nonetheless effective in most cases, at least where nodes are not very close to each other. Airlines run a similar arrangement, with regional airports feeding central hub airports like Heathrow and Chicago, which handle long-haul flights between them. Postal services, too, are hub-and-spoke models, often with several layers of hubs arranged as spokes around each other.

But typical social networks are not like that. In urban communities a lot of different networks live on top of each other. There are all kinds of random intersections and interconnections between disparate networks. It is all very fluid. There’s no central control: networks arise and die back as individuals need and use them. These networks don’t have any intelligence of their own: all the intelligence lives within the individual members of the communities. At network endpoints, in other words. Community members figure out which networks to join and what to use them for.

Neither the point-to-point or hub and spoke networks are efficient when people are often close to each other and sometimes distant, and where network needs are constantly in flux. In a dynamic, fluctuating community users need something that can do a bit of both.

Mesh network

There is, as Tony Blair once said, a third way. (There are doubtless others, but I don’t think you would thank me for embarking on a comprehensive survey of all network ontologies.) In this case, there are a great number of nodes, and most endpoints function as nodes too. the only difference between a true endpoint and a node is that an endpoint only has a single connection. Because there are countless nodes, nodes are not all interconnected but, instead, connected only to nearby nodes. Distant nodes are only indirectly connected through one or more intermediate nodes.

Now there are any number of indirect connection paths between any two nodes. The more nodes in the network, the more possible connection paths between them.

This solves all three of the problems identified above, and quite quickly. Firstly, it is easy, and cheap to add new nodes and endpoints to the network — each needs a small number of connections,: it may be as few as one, so the “arithmetic increase in cost to connect an additional user” problem does not exist. The network is easy to scale. The marginal cost of adding users is static, and it is borne by the connecting user, not the rest of the network. User pays.

Secondly, it solves the “single point of failure” problem of a hub-and-spoke model. As a mesh network scales, what does increase, geometrically, is “the number of potential connections between any two points”. The bigger the network, therefore — the more nodes it has, and mesh networks tend to have a lot — the more robust it is. The more resilient to failure. This means that there are no single, or significant points of failure. If you knock out a node, that only impacts that node, and any endpoints connected only to that node.

This is, indeed the fundamental problem that the U.S. Department of Defense’s Advanced Research Projects Agency — DARPA — was trying to solve when it formulated the principles for the ARPAnet, on which the modern internet was founded. The goal was to create a network that could sustain operation during its partial destruction, such as by nuclear strike. A mesh network is largely immune to targeted attack. If you want to knock out the network you must take out all its nodes. The more nodes the network has, the harder it is for a single impulse to destroy it.3

Thirdly, it solves the hub-and-spoke model’s “stupid-way-of-crossing-the-road” problem, too: since all nodes are connected directly to other local nodes and will always be connected to the ones closest to it, there will never be a need to go from Wood Lane to White City via Liverpool Street.

Problems with mesh networks

Of course, nothing is perfect and mesh networks have their disadvantages too. For one thing, the route any signal takes across the network is likely to be circuitous.

That is a problem if what you are sending is somehow secret. Everyone in the communication chain will get to see it. It’s also a problem if you are a control freak or, for some other reason, you need a predictable route. A mesh network is all very-seat-of-the-pants, make-it-up-as-you-go-along and ad hoc.

Furthermore, should there be a time or cost implication of sending a message, then mesh networks can be quite inefficient. The larger one gets, the more expensive, and slow, sending “content rich” messages becomes.

But there has been an information revolution in the last 40 years. Electronic signals move down a wire at the speed of light. Speed was not the constraint it once was.

But the resource impact of sending a message across a node — not speed of communication, but volume and format of information sent — presented another problem.

The variety of human communications

There is a down-side to there being an almost infinite number of pathways across a network. It means, to route a given message, every one of those pathways needs to be able to handle the message.

Say you built a physical “mesh” network that employed those cute little Citroën Amis to shuttle your messages between individual loading bay nodes on the network. The vehicles are smart, they drive themselves, using an algorithm to determine which nodes to use on the network pass. As long as you are transporting small people and the odd parcel it will work serviceably well. But if you want to transfer a live dolphin, the network cannot manage. You would need to re-engineer the whole network, and every point on it, to cope. You are stuck. You would have to start again.

Unless you can figure out a way of working around the chunkiness implicit in a live dolphin.

So, whatever your network topology there is always a design decision to be made: what is the universe of items that can conceivably be transported across this network?

It is an optimising function, rather like the one we take when buying a car. We know most of car our journeys will be short and involve one occupant with little luggage. For these, a Citroën Ami would be perfectly adequate. Better, in fact, as long as our friends don’t see us. You don’t need a Land Rover with a snorkel to get around the Hampstead Garden Suburb.

But there will be times when we need to collect the kids from karate practice, take old furniture to the dump, or go off-roading in Wales. It is worth “solving” for these contingencies. But every now and then it might be useful to have a minibus, or a tractor. But we don’t optimise for these extremes: we just hire in the equipment, or the man with a van, as we need it. The “network” has its limits.

Designers of physical networks — even for mesh networks — must do the same exercise. They will optimise for known use-cases, but cannot be expected to predict future use-cases that might come along as technology develops. This is a shortcoming of all models of network design — if you build tunnels that are only ten metres wide, that forever precludes putting eleven-metre wide vehicles on your railway. So, along with a rail network (hub-and-spoke) there is a road network, which is much more like a mesh. The railway is very good at certain transport functions — passenger commuting, or hauling coal around – but not good for nipping up to the highstreet to collect your dry cleaning, or ingredients for borscht.

Because the link count in a mesh network is so large, and chaotic, capacity constraints are a particular limitation. This leads to different arrangement of structure and intelligence. For a hub-and-spoke network there is a real advantage to heavily engineering and controlling the central parts. It doesn’t matter of some things can’t go on the railway because there are aways other networks: the road, sea, and air, that can accommodate them. So railways and their designed-on rolling stock are heavily engineered to work together, and closely controlled by a centralised, intelligent monitoring system.

But central control of a system has its drawbacks. It is a single point of failure.

Any London commuter will know that a central signalling failure can lead to widespread disruption. End users can’t work around it unless they get off the network and use the roads — being a different kind of engineering proposition. The engineering of roads is minimal, and while in urban settings they are controlled, it is lightly. If all the traffic signals go down, the network functions: drivers just have to be a bit more careful.4

In any case there are two design principles: engineering and intelligence in the middle, or intelligence and engineering at the edges.

A railway is a heavily engineered, centrally controlled, intelligent network. All the intelligence is in the middle, and the edges are really easy. You don’t need any particular kit to ride a train other than a ticket. You can just sit there. You just have to remember where to get off.

A road is simple, mainly dumb network, with little central intelligence. All the complication, design and intelligence is “at the edges”. Users must bring their own vehicles, and they have to operate them. They have to figure out where to go, by which route, and how to operate their vehicle. The road network is mainly passive. It just sits there. You have to worry about where you are going. The road doesn’t care.

Internet as a dumb network

So there are smart networks and dumb networks. What about the internet? You could be forgiven for presuming the world wide web—surely the most sophisticated distributed network in the known universe—is highly intelligent. In fact, it is not. It is a supremely dumb network. That, indeed, is its very brilliance. The world-wide web could hardly be stupider. All the brilliance is at the edges.

This is partly a function of its genealogy. They built the digital world wide web on a network that was already there, that was designed with a completely different use-case in mind: analog telephone signals.

A traditional telephone mouthpiece worked by converting sound waves into an analog electrical signal—a continuously varying voltage describing those sound waves that travelled to the exchange, passed through a series of switches and down another wire to the other caller, where the receiver’s ear piece speaker does the reverse: converting the analog signal back into sound waves. An analog system was a continuous pipe. The exchange would physically dedicate a continuous electrical circuit between callers for the duration of the call. It was like a private, dedicated tunnel. It persisted whether anyone was speaking. It was inefficient for data. The internet wanted to send binary digits — lots of ones and zeros — down the pipe. It did that by converting them into audible tones that the phone line was expecting. That is the famous modem noise — youngsters probably don’t remember it, but for people of about JC’s age it was a thing of marvel and wonder.

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For those bewitched by the unravelling convictions of postmasters, LIBOR rate setters and antenatal nurses Traitors is a superb, but unsettling model. It shows how easily we — be we contestants, viewers, witnesses, prosecutors, judges, juries or poundshop Poirots — can be mistaken, even about very obvious things. How inevitably, where the facts and social dynamics before us are inchoate or contrived, or calculated to mislead, we will be misled. The same cognitive habits and heuristics, that serve us well as we navigate our ordinary worlds of straightforward surfaces and familiar social relationships, lead us astray when we are asked to play strange games of misdirection with unfamiliar participants.

These are “games” not in the senses of parlour games like bridge or chess or even poker, but language games: hermeneutic constructs built from artificial conditions and contradictory and only partially disclosed rules. Where players can reach their objectives only obliquely, while appearing to head in the opposite direction. There are some parlour games like this: Secret Hitler — great fun as long as you don’t mind being accused of fascism — has a similar dynamic.

There are other common situations like this in our lives. The workplace — often a nest of sharp-elbowed misdirections — is one. So is any political organisation: the clue is in the name. The criminal justice system is another.

Traitors is a fully-designed exercise in the wilful perpetration of injustice. Of the twenty-two initial contestants, three — according to the canonical rules — “deserve” to be banished. The others are pure in heart, if not in deed. But even that is a misdirection: all players in the game have the same object— to win it — and that, whether you are traitor or faithful, involves eliminating all the other players. The trick is to to be seen to do as little of the eliminating as possible. The winner is the best at misdirection.

How to play

For those living under a rock, the comatose and the deeply uninterested in popular culture, here are the principles of the game. Calling them “rules” is a bit of a stretch.

Twenty-two contestants convene at a neo-gothic castle near Inverness, hosted by Claudia Winkelman. Having bonded briefly, the players are sat around a round-table and blindfolded whereupon, theatrically, Winkelman assigns 3 of them the secret role of “traitor”. The remainder are the “faithful“.

The traitors will shortly meet in private, so have certain knowledge know who each other are and therefore, who are faithful. The faithful know neither. They only know their own status and, about that, to other faithful they are unreliable witnesses. This is a key information asymmetry. It gives traitors an enormous advantage.

For the faithful, their putative objective — we will come to why it isn’t their actual objective — is to identify and eliminate traitors. They have one opportunity each day to do that, during a banishment session convened at the round table where players debate who seems suspicious. At the conclusion of the roundtable debate players vote to eject one of their number, based on whatever meagre information presented to the table that best persuaded the congregation. But all participants, including the unknown traitors, participate in the roundtable. The odds are therefore somewhat stacked against faithfuls even in the use of their own most powerful weapon.

Each person who pleads her own case, or casts aspersions about another’s, is an unreliable witness. The roundtable is like a jury in every respect but one: “jurors” are players, guilty and innocent, and therefore also participants in, or witnesses to, the crimes alleged. Each has a stake in the outcome in a way a juror does not.

Given the paucity of information, players’ pet theories are inevitably bunk. This is obvious. Everyone can see it. I’ve lost count of the numbers of times I’ve heard people say, “it’s mad they all get het up because the elimination process is basically random.”

When, occasionally, they do stumble on the truth — an inspired aspect of the show is the confessional segments wherein individual players disclose their innermost suspicions to the audience —contestants usually trip over it. Being no surer of themselves than any other players, those who are onto something are usually talked out of action.

There is another elimination mechanism. The traitors, most days, confer in a secret conclave to agree upon the “murder” of a faithful. Murders take place unwitnessed and off-stage: the traitors leave no direct evidence: If the faithful want to catch a traitor, they must use their powers of deduction and inference on the strength of whatever weak circumstantial evidence they can find that give the traitors give away: tics, oral slips, guilty looks, conspiratorial behaviour — that kind of thing.

In the meantime the characters participate in “missions” where they must cooperate to add money to the prize pool. Here, traitors’ and faithfuls’ interests are aligned. This is in some ways clever, but in others, a weakness in the show’s format: it would be better if the traitors stood to benefit by jeopardising the faithfuls’ prize pool somehow. It might give faithful more concrete material to go on at the roundtable.

As it is, there is precious little: before and after the mission contestants have time to interact, air their suspicions and eke out information about each other but only from an inert “data set” that does not really contain any useful information. The game is carefully constructed to avoid traitors ever leaving unambiguous evidence of their identities, except by accident. As long as the traitors have been circumspect, there will no meaningful clues from which anyone could draw a sound conclusion.

In any case, at least one of the traitors is certain to survive to the “final five”— the rules are, literally, rigged as the game progresses to ensure this: television schedules, and not game dynamics, require it. But players should nonetheless factor it in: there will be traitors at the death. There must be. The game would not work without them.

A game of chance

What is fascinating is how players approach a situation in which they must make important decisions with almost no reliable information. Traitors is a show about deception, and it perpetrates its own deceptions on the players, in plain sight, from the outset. It tells them their objective is to identify and eject traitors. But it is not: traitors will in any case “respawn” if their numbers dwindle. Each player’s objective — traitor and faithful alike — is simply, and only, to survive. They should do nothing that jeopardises that objective, including displaying skill at identifying traitors, and thereby presenting an apparent threat. The best strategy is to keep your head down, keep your opinions to yourself, and say nothing unless spoken to. Be the zebra in the middle of the herd.

For Traitors is a game of ostensible, but not actual, strategy. It is, by contrast, a game of pure chance.

At the outset there is maximum uncertainty: players have nothing to go on but resting probabilities. These are easy enough to calculate: once their roles are nominated, each faithful should know there is a 3 in 21 chance — that’s 1 in 7, for the hard of mathematics — of any other player being a traitor.

And then the game commences. Of the 19 original innocenti, at least 15 must, by the rules of the game, be thrown under the bus. They will not all be murdered: more than half will be ejected by the faithful at the roundtable. Murder victims are necessarily faithful — the traitors cannot murder each other — but it is a necessary consequence of the game that most round-table ejectees will also be faithful. They are “murdered” too, only by a council comprising a large majority of faithful.

All that really differs between traitors and faithful, therefore, is their means of killing other players: traitors by murder, faithful by banishment. Presuming they don’t cheat, “traitors” are no less “deserving” of success than “faithful”.

For the thing is: as far as players have any control over outcomes, the elimination process isn’t just basically random: it’s completely random. Players, like viewers, must know this, yet they persist in believing they can anticipate and even influence outcomes — and, for the sake of watchability, just as well: if they did not, the show would not work. The game obliges players to willingly suspend their own disbelief. For all the good their uninformed machinations do them they would be better, and happier, were they to leave things to chance.

If faithful players can discipline themselves into thinking in terms of probabilities, they will note some reliable posterior information does emerge as the game goes on: as the roles of eliminated players are evealed — all murdered are ipso facto faithful, the banished declare their allegiance as they depart — so remaining faithful can update their “priors” somewhat, though, again, their information is incomplete.1 Faithful players’ odds systematically shorten — get worse — as the game progresses and contestants are whittled down. Elimination overweights the faithful, so as players disappear, the higher the probability that remaining competitors are traitors. By the time of the final five, at least one and probably two of the players must be traitors — that can be deduced from the fact of ongoing nightly murders. This means, for a given faithful, the “traitor ratio” amongst the remaining players increases over the game from about 14% to between 25% and 50%. That is an inevitable consequence of game play.

Most seem unaware of this. They must surely know it, at some level, but if they do, they don’t seem to care. For despite it, remaining players form strengthening bonds. Their sense of “ordeal camaraderie” is at least as strong as their willingness to suspect their comrades are traitors. Thanks to their improbable longevity surviving players, whatever their allegiance, have more in common with each other than any player has with a fallen comrade.

There is a good reason for this: when push comes to shove, individual faithful are no less incentivised to murder — or, by the end, guilty of it — than traitors. Traitors is a gave of push and shove. It is also a fantastic illustration of just how hard it is to make good decisions in times of uncertainty.

No killer facts

The game is carefully constructed so that the faithful are never presented with unambiguous evidence of treachery. It can happen, but only by a traitor’s unforced error.2 As long as the traitors are not careless, they can avoid leaving direct clues and the faithful must form suspicions based on inferences that are basically bunk.

This, as Traitors series across the world — there are editions in the US, Ireland, Australia and even little old New Zealand — has consistently illustrated, is incredibly difficult to get right, except by fluke. It’s little wonder: the faithful are (mostly!) perfect strangers to each other. They don’t know how each other behave in normal social situations, let alone times of social stress or the state of prolonged contrived deceit that Traitors forces them into.

Their suspicions are usually wildly wrong. Viewers, who know who the traitors are, find the faithfuls’ utter guilelessness at the same time mesmerising and exasperating. We howl at our televisions. We clutch our heads in exasperation. “How can you possibly miss it?!”

But this is a perfect example of hindsight bias. Of course it is obvious when you know who the traitors are. We are deceiving ourselves if we think we could do better.

The game environment is highly artificial: all players, not just traitors, are motivated to lie and disguise their true opinions in ways they ordinarily would not. A faithful who believes she is “onto” a traitor will keep her opinions from the traitor, but will readily share them with others — who may include the traitor’s confederates. This obligation to engage in duplicity leads even the faithful to spin and perpetuate dishonesties the same way traitors do. This is a neat design feature: the natural advantage the faithful would otherwise have, of having nothing to hide, is extinguished.

Some are better at this then others, but the cognitive load in trying to draw inferences from minimal available information often manifests in erratic behaviour, as faithful scrabble helplessly to get some purchase on who is who and what is what in the game.

This erratic behaviour is often mistaken as “traitorous” and those exhibiting it banished. Usually, it is quite the opposite: with their superior information and greater sense of jeopardy, traitors tend to have a much better “game plan” than faithful. They are generally more careful and rational because they do have a plan. This, ironically, tends to stave off suspicion! The faithful tend systematically to banish each other on dismal pretexts, while the traitors continue to get away with murder, literally, undetected and even unsuspected.

As the game unfolds players tend to form alliances. Across the Traitors’ regional franchises, the way they do this differs in a way that, amusingly, reinforces cultural stereotypes: the the Brits are self-effacing, charming, polite and deferential, especially at the beginning. They tend to eject players who are not polite. Irish are cheerfully idiomatic in their interactions. Australians, from the first morning, are brutal.

The British “celebrity” edition of Traitors, in 2025, was a nadir Britishness. Random British contestants are pretty bad at detecting traitors, but do they tend to get some. British celebrities, as you might expect from a bunch of luvvies, grovel disingenuously to each other at all times, in contrived mutual deference, and prove therefore quite useless when it comes to identifying traitors.

There are some learnings from this. An obvious one: in situations of epistemic uncertainty, when people you cannot trust are motivated to present a particular view of the world, we are really bad at figuring out who is telling the truth. Worse even than a choice at random.

This has real-world implications. Traitors might seem contrived, but it tracks the commonplace. For most of us, complex situations of factual uncertainty where conflicted agents spin facts to suit their own agendas, is an everyday experience. This is how parliament works. It is how the media works. It is how most workplaces work. And it is, explicitly how justice works: the “traitors’ dilemma” is exactly the scenario faced by a criminal jury. Who is faithful? Who is a traitor? Who is spinning? What is relevant? What is a red herring?

Like the faithful, jurors have limited information to go on. It may not be everything. It may be wrong. It may invite prejudicial inferences that are not justified.

Misconceptions

Traitors is so beguiling because it is based on a couple of misdirections. For one thing, the faithful are not the good guys: the “faithful” and “traitor” labels are a misdirection. There are no innocents in Traitors. The inevitable probabilities of the round table gives the lie to the idea that the “faithful” are really the good guys. Over a series there will be some 12 round tables. A banishment at each is compulsory. The dynamics of the game require contestants, faithful or not, to winnow themselves down to three finalists. The faithful have no power to save each other to avoid this.

This means the faithful must compete for survival against each other just as fiercely as they must against the unseen traitors. The traitors, conceivably, could all make it to the final. They have slightly more incentive to be collegiate than do the faithful, which is ironic.

Over the course of the game, the faithful typically eliminate more of their own than do the traitors. The familiar refrain, “I’m faithful, 100%” is not quite the ringing endorsement of probity its seems. Being faithful just means you intend to eliminate people in public, not private. The faithful is, in no sense, a “team”.

Unconscious bias?

In recent times, collated game statistics across five seasons of Traitors have prompted questions as to whether the collective decisions made in roundtables and the ”turret” reveal the unstated, even unconscious, prejudice?

Banishment data from early rounds invites the inference that there is mild bias against minorities and older players, who are often ejected first.

We should not be surprised at this. It does not prove prejudice. Firstly, in a novel situation of great uncertainty, informed decision making us impossible: literally there is no information. The players know the baseline probabilities — there’s a 1 in 7 chance of another player being a traitor, so a given contestant is, most likely, not a traitor. This is a dissonance though, because the players also know that three definitely are traitors.

A good Bayesian uses what information she can find to provisionally improve those odds. This is a subjective process, to which she will bring all her life experiences. A person who appears easy to trust has a marginal advantage. Here “in-groups” and “out-groups” might make a difference. We are all, instinctively, inclined to trust those with whom we are familiar — those our accumulated experience of the world tells us are likely to share our experiences, impressions and values — and those we form an interpersonal connection with.

These will often be people who most resemble us — by age, sex, cultural background, occupation, interests, geographic origin.

This is no kind of positive discrimination against those who don’t resemble us — they keep their base line odds — but a concession towards those who do.

Those common connection points are often cultural. Ethnic, religious and racial identities often follow cultural ones.

I can illustrate this with my own “minorityship”: though I live in the UK, I am from New Zealand. There are not many Kiwis in the UK — come to think of it, there aren’t that many in New Zealand either — but in the UK we make up about 0.1% of the population, though, like sand in a picnic rug we do tend to get everywhere.

Though my own connection with Aotearoa is slim — I’ve spent the vast majority of my life in London — should I encounter another New Zealander in the UK, we will quickly connect. We have shared experiences. We can make assumptions about how each other will think. We’re also likely to have been to school with each other’s cousins but that is a different story. The connection might not last — some kiwis are jerks — but all other things equal it is a good starting basis.

This is exactly what is happening on traitors. The great majority of contestants are under 45. The cast reflects the ethnic diversity of the UK, which is predominantly Caucasian, and geographic make up: there are always a couple of Welsh and Scottish but a majority from England. We should expect these people to instinctively bond with in-groups, the same way ex-pat New Zealanders do.

No surprise, the “bias” effect in the data wears off after a few days, by which time participants have got to know each other and have adjusted their perceptions based on actual evidence. We are natural Bayesians. We update our priors.

As the game wears on contestants get no better at picking traitors, however. They consistently allow obvious confirmation bias to override their better judgment. We are astounded at their credulity. We should let it tell us more about our own.

Complex system

Traitors is a perfect model of a complex system. Not only are their autonomous agents making uncontrollable decisions and stark, but shifting asymmetries in information, but the “rules” of the game are opaque and amorphous. Some are disclosed late, others are never disclosed and some change without warning or notice. Generally the rule changes are engineered to favour the traitors, but not always. Secret traitors are introduced. Players are unexpectedly ejected before the game starts, and then reintroduced, just as unexpectedly, later.

Players are therefore in a situation of uncertainty, not risk. Risks you can manage; uncertainty you cannot. The players’ efforts to manage uncertainty and work each other out are doomed not only to fail, but to sow seeds of doubt and resentment in other players. This rancour ossifies into factions, and hostile subgroups. Of course, the traitors merrily stir up this rancour. The net effect is that the faithful get even worse at guessing traitors than random.

Players may as well be in a lottery, where an elimination is drawn from the group, and a murder victim selected from the faithful, at random each day. If they all resigned themselves to that fate, they could relax, enjoy the game, enjoy each others’ company, and let fate’s cold hand decide, without blaming it on any player. This would completely spoil the spectacle for viewers, of course: who wants to watch a bunch of random strangers having a nice time in a Scottish castle?

We, and the networks, can therefore be grateful it never occurs to any of the participants that they have no control over the game. They carry on as if they can beat the game, and each other, with their cunning. Even after the Faithful have ejected eight of their own and just one traitor — even when players they profess to be convinced are lying repeatedly turn out not to be — it never occurs to anyone to abandon the psychodrama and just draw lots.

Traitors as a model for the workplace

Similar group dynamics exist in the workplace, especially where it comes to promotion and preferment.

If you can influence outcomes with certainty, it informs how you “play the game”: being political may pay off — forming and then tactically defecting on alliances, exaggerating your role on things you were involved with, and taking credit for things you were not — even if this destroys relationships with those whom you are outmanouevring — makes sense. It is — should be —management’s job to impose incentives and structures inside the system that discourage this kind of behaviour. Most management fails to.

For if you can’t influence outcomes — if the rules are shifting and unclear — if the decision-makers to whom you appeal are themselves subject to just the same game-playing and caprice, whose fortunes, like yours, may ebb and flow — then you cannot know whether your gamesmanship, like that of a “faithful” in a game of traitors — will pay off or sink you.

You are better to let the river take you where it will, building as you go enduring and healthy relationships around you. Being useful, agreeable and unthreatening is a sensible tactic for a safe but unspectacular career. Most people in professional services have long since figured that out.

The workplace is different from Traitors and Squid Games in an important respect: Traitors is a finite game; the workplace is an infinite one. There is no equivalent to Traitors’ known common general objective of elimination. There is no end-point at which a player wins. At work, the objective is just to keep playing. Relative advantages are often transient.

We think we know “the rules of the game”, but the game is complex, the rules are opaque, and they continually change with the continually changing market outside and internal organisations and priorities within. From where most of us sit, the “rules” — if there even are any — that govern our advancement may as well be random.

This is what propels the experimental finding from 2010 that organisations that promote people at random do no worse than those with extensive performance appraisal processes.3

Curiously, “the rules being random” may be a better outcome either way, if it leads to staff prioritising cooperation, collaboration, informal relationships and trust over “playing the game”.

This is part 2 of an essay. Here is variation margin: deep history part 1. There will be a third.

Refresher

Prompted by the simple question “why do Americans prefer collateral pledges and Brits prefer title transfer collateral?” we were talking last time about the difference, in the JC’s argot, between “collateral” on one hand and “security” on the other.

In this sense, “collateral” is something you give bodily over to your creditor. “Security” is an enforceable legal promise you make over assets you keep hold of yourself.

These are quite different modes of performance assurance. They have different effects when it comes to doing the two things any lender cares about: managing the debtor’s credit risk and managing the creditor’s cost of funding the debt.

Another quick definition pit-stop: I sometimes refer to “borrowers” and “lenders” here, but more properly I should say “creditor” and “debtor”, because the same principles apply whether you have extended a formal “loan” or you are simply owed money under some other credit arrangement. A swap, for example, is not a formal loan, but any mark-to-market exposure under a swap, economically, is the same as a loan: specifically, like an overdraft, with a fluctuating balance accruing interest at a floating rate.

Now, since, when discussing loans, most lawyers rarely think past credit risk, we spoke a bit about the seldom discussed but vital, business of funding optimisation. We will do a bit more of that in this episode.

Along the way we will encounter Shylock, Spinal Tap, the Osmonds, the widow Herring, a nice fish restaurant overlooking a beautiful lake in the Ostallgäu and a resourceful young private in the house band of the 101st Airborne by the name of James.

Dans une coquille de noix

In part two of this essay I will trace the development of financial collateral from pure credit mitigation — from no collateral to customary liens to pawnbroking arrangements — to modern margin arrangements which introduce an important new feature: funding cost management. How can a creditors use collateral posted them to offset or optimise their costs of funding their exposure?

For most of history, security interests and even possessory collateral served only the purpose of credit protection. Funding management couldn’t come into it because the assets involved were unique, illiquid, or both. The creditor was obliged, therefore to just sit on them.

But just sitting on productive assets and not using them is a cost and a missed opportunity in any business. Finance is no different. We will see how as fungible, liquid financial instruments emerged in the 19th century, institutional creditors began to monetise their collateral portfolios, converting them, temporarily, into cash. The modern derivatives market developed out of that capability.

Though we started looking purely at collateral arrangements established to offset the risks and costs of extending credit, we will pause to notice how these arrangements resemble, very closely, other kinds of financial transaction in the market place. There is a sort of fractal similarity here. This idea of funding optimisation is embedded in every aspect of the financial markets.

But let’s not get ahead of ourselves. Let’s start at the beginning. There’s a good play about this.

Play the movie. Ja. Play.

Collateral as a credit tool

A pound of flesh?

Shylock: But ships are but boards, sailors but men; there be land rats and water rats, water thieves and land thieves—I mean pirates—and then there is the peril of waters, winds, and rocks. The man is, notwithstanding, sufficient. Three thousand ducats. I think I may take his bond.

The Merchant of Venice, I, iii

Shylock, you may remember, could not take collateral, or security, but had only Antonio’s word as his bond: Antonio was, in the vernacular, “expectation-rich, but asset-poor”: all his worldly possessions were out and about, on the water, in pursuit of riches but at the mercy of the land rats and water thieves of the seven seas.

Shylock was right to have been worried. It all went horribly wrong for Antonio as buccaneers on the high seas laid low his assurances. It hardly worked out any better for Shylock — xenophobia and the finer points of Venetian contract law — did for his, but at least drama fans got a pleasant evening out if it. But all this — well, drama — for the want of tangible performance assurance.

The famous “pound of flesh” is a kind of security, but it is not “collateral”. We could, therefore, regard The Merchant of Venice as a morality play about the danger of uncollateralised lending.

But collateralised lending goes way back before Shakespeare’s time, of course.

Collateral 101: credit risk

From the dawn of history — as Nigel Tufnel might say, hundreds of years before that — private lending arrangements have involved credit risk. That is their fundamental wager: I lend you money; you spend it. I hope you are wise enough, and honest enough, to give it back.

The amount a debtor pays for the privilege of obtaining credit represents two things: the “time value” of the money borrowed — the opportunity cost of extending credit to this debtor and not using the money for something else — and a “credit spread”: a “premium” representing the creditor’s assessment of the risk the debtor won’t pay it back.1

Whether a debtor repays depends firstly, on its honesty and secondly its solvency: its general business acumen over the period of the loan. This is a matter of a creditor’s personal faith: credit is, literally, latin for “he believes”.

Credit risk is not hard to get your head around, and lawyers spend an awful lot of time worrying about it.

Traditionally, there are three ways to manage it: by taking “security”, by taking “collateral” or by obtaining “sureties”. A quick reminder: I treat these three concepts as mutually exclusive in a way that does not really reflect common usage. Lawyers are oddly casual in their terminology here.

Security

Creditors can take security — the debtor grants the creditor abstract legal rights over some of its assets, but continues to hold and use those assets. For example, a mortgage. The debtor lives in the house, but if she does not keep up her payments, the creditor can turf her out and sell it to recover its debt.

Collateral

Creditors can take collateral — the debtor physically delivers assets to the lender for safekeeping, as a bond against repayment. For example, a pawnbroking arrangement. The pawnbroker holds your asset until you repay your loan, and can sell it if you don’t.

Sureties

Creditors can take sureties — a trusted third party underwrites the debtor’s obligation to the creditor. A guarantee or a letter of credit. I mention sureties for completeness: I am not going to dwell on them as they aren’t really practical funding mitigants.

I don’t want to get ahead of ourselves, but in the 19th century creditors began to look for ways to reduce the absolute cost of money they were lending, and wondered whether their credit mitigation arrangements might help.

Physical collateral: liens and pledges

Taking physical collateral against a debt obligation is as old as civilisation. Its simplest, most customary form is the lien.

Liens

Liens are “customary” in the sense that they did not grow out of some brilliant legal innovation but were an existing cultural practice that the law simply recognised.2 A lien is the original “self-help remedy”: oh, you want your watch back? Pay your bill.

Possession is nine-tenths of the law. Liens are all about possession. They arise automatically and without formality: when you take your car in for a service, the mechanic can hold onto it until you have paid your bill. Say, after an agreeable meal at the delightful Fischerhütte in Hopfensee, you are caught short. The proprietor points to your watch as a condition to letting you out the door.

This is mostly an honesty play, rather than a solvency one: what matters isn’t the watch’s realisable value so much as its value to you, and the hassle of having to replace it. Herr Fischer has very little interest in selling your watch: he is in the business of serving up Zanderfilet mit frischen Kräuter-Rahmschwammer rather than hocking off collateral to settle his debts: he just wants his punters to enjoy their perch and pay their bill. It is very good by the way.

Primarily, liens are a practical lever to make sure debtors do the right thing. They are an assurance mainly, of honesty. They not a great mechanism for recovering debts if they don’t. Hence — as with a mechanic’s lien over your car — the collateral value is often out of all proportion to the debt. The practical value of a lien is its awkwardness. Even a bankruptcy administrator will find it financially expedient to settle the lienholder’s bill — or walkaway altogether — than challenge the effectiveness of a lien.

We can see here the power of sentimental value. It brings the borrower back to the table regardless of any rational assessment of value the collateral. But you can take it a bit far:

The original human shield

A quick amusing sidebar, for which I am indebted to regular correspondent Mr. Johnston, who is a bottomless source of such ribaldry: the old case of Herring v Boyle (1834) 1 CM&R 378.3 It concerns a schoolmaster, Boyle, attempting to extract school fees from a widow, Mrs. Herring, for the education of her 10-year-old son. On Christmas Eve Mrs. Herring arrived at Mr Boyle’s school to collect her lad for the holidays. At the time she was up-to-date with her fees, but a new instalment was due the following day. Fearing he might not see the pair again, Boyle took an imaginative, if idiosyncratic, approach to the situation. In effect, he asserted a lien over the lad. You may have your son, said he, once you have settled your fees. Mrs. Herring was, at that moment, indisposed.

Denied his Christmas hols, Herring Minor sued. The headnote from Crompton, Meeson & Roscoe’s law report is entertaining:

The plaintiff, who sued by his next friend, was an infant about ten years old. He was placed by his mother, who was a widow, at a school kept by the defendant at Stockwell. The terms of the defendant’s school were twenty guineas a year, payable quarterly. The first quarter; which became due on the 29th of September, 1833, was duly paid. On the 24th of December in the same year, the plaintiff’s mother went to the school and asked the defendant to permit the infant to go home with her for a few days. The defendant refused, and would not permit the mother to see her son, and told the mother that he would not allow him to go home, unless the quarter ending on the 25th of December was paid.

We must at any rate take our hats off to Mr. Boyle’s Dickensian Christmas spirit. Especially since the debt had not even fallen due. Sadly Herring minor argued the case as a trespass to the person and not an unenforceable lien so Mr. Boyle was denied the opportunity develop new jurisprudence of customary possessory security interests over natural persons.

It would have been fun to see what happened had Mr. Boyle tried to repo young Herring into the chimney-sweeping market.

Come to think of it, that is more or less the plot of Oliver Twist.

Pawnbroking and the third stone from the sun

Anyway. Let us move from unrealisable liens to realisable ones. These we see in the context of pawnbroking. Pawnbroking has something of a rock ’n’ roll flavour to it, as Major Charles Washington of the 101st Airborne division recounts in this great story about about one of his paratroopers, one Private Hendrix:

As you know, Jimi was a left-hand player. That being the case, he would have to string his guitar with the strings upside down, the heavy strings in reverse of what they normally should be.

This was okay in itself, with the one exception: Jimi, somehow, would always manage to pawn this guitar before a gig. And of course, the band would have to go re-pawn it, repossess it.

Nothing else could be used. Of course, he had to have this specific guitar. And I think he played this particular angle against the band.4

As an aside this is quite clever financial structuring by Private Hendrix. In essence he is extracting cash upfront monetising his own performance by having his bandmates redeem his loan. Whether they set that off against his gig fees is not reported.

In the context of pawnbroking, the liens is more formal. Here you hand over your Stratocaster strung upside down for a m—g genius explicitly as collateral for a short-term loan.

Pawnbrokers double as second-hand stores so, unlike restaurants (and school masters) they have a ready-made mechanism for quickly realising the value of collateral assets. And they will use it. As long as it complies with the consumer credit regulations — which tend to focus on the terms of the loan rather than the terms of security enforcement if it is not repaid — the pawnbroker has little incentive to obtain a price much higher than the debtor’s accrued liability.

Here are all the elements of a modern collateral arrangement, but one: A money debt advanced against bodily delivery of a valuable asset — a Stratocaster strung upside down for a m—g genius — for safekeeping. Legal title does not (at first change) hands: if all goes well the broker must return the asset to its owner (Private Hendrix) upon settlement of the debt (in this case, by Major Washington on Private Hendrix’s behalf). Private Hendrix remains legal owner of the asset throughout.

The one missing element is that the pawnbroker may not deal with the collateral asset in the meantime. It must look after it throughout the term of the loan. It might sound obvious, but the broker cannot, until the loan defaults, sell the borrower’s asset. Imagine if Private Hendrix returned, an hour before the gig, to find his Stratocaster strung upside down for a m—g genius had been sold? Actually it is not that hard to restring a Stratocaster, but it sounds like Major Washington didn’t realise this).

Why would a pawnbroker want to sell a pawned Stratocaster before the loan fell due? Well, think about funding. The pawnbroker is advancing money to Private Hendrix. It must get that money from somewhere. It must borrow it, and pay interest of its own. If only it could somehow sell Private Hendrix’s Stratocaster strung upside down for a m—g genius — temporarily, during the term of the loan, and quickly buy it back again when Major Washington came to collect it, the pawnbroker could offset its own borrowing costs. In stead of an inert asset — it may be a Stratocaster strung upside down for a m—g genius but to a lender it is still a dead weight — it would have more money to make more loans to other borrowers.

Aside from the fact that that just is not the deal, a few things make this hard: a pawn loan is typically short, the pledged assets are typically hard to buy and sell quickly, and each asset is unique: this Stratocaster, however it is strung, is not identical to that one: Major Washington wants Private Hendrix’s original Stratocaster back.

The pawnbroker leaves quite a bit of money on the table, therefore. Its funding position is not “optimised”.

For the longest time, this was simply the deal. If you want to finance assets you need an independent source of funding. The assets have to just sit there, inert.

But as they self-organised and formalised over the 19th century, the financial markets would change all that. With a heavy heart we are now going to leave Private Hendrix behind and turn to the financial markets.

The emergence of the monetisable asset

Enter the financial markets

Over the course of the 19th century, financial markets in the western hemisphere evolved from informal wagers in smoky coffee houses to organised venues where traders in silly blazers would gather to buy and sell financial instruments, shouting odd things, pulling odd faces and giving each other odd hand signals. Legal systems developed increasingly sophisticated means of granting security like debentures, pledges, charges, floating charges, equitable assignments and trusts.

At the same time the emerging classes of financial instruments, bonds and shares especially, presented new opportunities. They were different from the sorts of assets a pawnbroker might take in.

It is a bit unfortunate that the market settled on a misleading label for these instruments: “securities”. This is confusing, because on the whole, they are not “secured”: they offer no better “security” than any contractually binding promise to pay. One class — shares — do not even do that.5 Since we are talking here about “security” in the strict sense, I will avoid using the same word to describe “unsecured financial instruments”.

“Instruments”, I know, sounds old-fashioned, but it has the advantage of being clear.

The value of a financial instrument lies in its nature as an abstract legal construct. Financial instruments are, in essence, carefully articulated, transferable promises. Because the whole point is to syndicate a big borrowing amongst a large number of small investors, and to let them trade between themselves, an issuer’s financial instruments tended to be subdivided into series of small, identical instruments.

Financial instruments don’t depreciate the way conventional assets do. Indeed, they appreciate. Being abstract legal rights, you can’t prang them. They won’t rust, break, malfunction, or go off. Individual instruments in a series remain materially identical to each other throughout their term. There are no-individual vicissitudes that mean this instrument is in “immaculate condition” and that one is merely “acceptable”. They are identical: in legal lingo, instruments of a given series are inherently “fungible”.

And there was a liquid market where these instruments could be bought and sold every day.

So collateralised lenders might have been forgiven for thinking:

Hang about. I have a big portfolio of assets various people have given me as collateral for all my loans. Now, on any day, loans and borrowers may come and go, like tears in rain, but the ongoing value of my collateral portfolio remains pretty stable. And this collateral is comprised of financial instruments. These are useful assets, yet here I am just sitting on them. That costs me money, in custody and clearing house charges. And while I sit on them, these assets are not working for anyone.

This feels like — opportunity.

Optimising funding

Somewhere out there, lenders pondered, there must be a way of working this to an advantage. If only we could somehow use the collateral assets we have been pledged. If only we could raise money against them. If we could do that, we could dramatically reduce our lending costs. We could shrink our balance-sheet. We could create space for more loans.

If a lender could sell the collateral asset on receipt — covert it immediately into cash — and then buy a fungible equivalent asset back at maturity, the lender wouldn’t need to borrow the money from its treasury departments at all: as long as it was quick and juggled expertly, its collateralised lending book would “self fund”: the lender would raise the money it needed to lend by “monetising” the collateral provided by its borrowers.

Self-funding loans from pledged collateral: now wouldn’t that be a fine thing?

So there we have it: fungible instruments and liquid markets finally solved the pawnbroker’s ancient problem. Lenders could now monetise collateral portfolios, achieving the self-funding loan. Over time, derivatives markets evolved the structures to capitalise on the unique properties of financial instruments as collateral assets.

But this financing logic doesn’t just apply to explicit loans and collateral arrangements. It applies to the swap transactions themselves.

And here we are going to leave it, until next time.

This is what I would call an “Albert Haddock” case. Albert Haddock was A. P. Herbert’s ornery civilian litigant, always getting himself in trouble, or up the nose of the authority, presenting negotiable cows to the revenue, when on a flooded road arguing that vessels should pass starboard to starboard and so on. Albert Haddock is fictional. His real-life counterpart here is a chap called Dan Neidle. Mr. Neidle should understand I mean “Haddock” in the most reverential way: the JC is a big fan (of both Messrs. Haddock and Neidle). I like people who “poke the Borax”1 and I have no great fondness for civil litigators. And as we will see, there is nothing quite like a bit of “Neidle needle”.

That said, the ultimate outcome of this case, in which Mr. Neidle’s antagonist was exonerated from disciplinary charges sent his way, seems right. We will come to that in good time. First, the facts.

Facts

In July 2022 Dan Neidle, nowadays something of a public provocateur on matters of tax policy, but for many years Clifford Chance’s head of tax, published some embarrassing allegations about the tax affairs of the then recently-appointed Chancellor of the Exchequer, Nadhim Zahawi.

Unwisely — has no-one heard of the Streisand Effect? — Mr. Zahawi “went to the mattresses”. He engaged a firm of solicitors to shut Mr. Neidle up.

That firm of solicitors was Osborne Clark. Carriage of the matter fell to one Ashley Hurst, a litigation partner.

Mr. Hurst’s first instinct was sensible: he messaged Mr. Neidle suggesting they chat. Mr. Neidle was having none of it. He told Mr. Hurst to put whatever he had to say in writing.

Mr. Hurst replied, “Trying to avoid that. We can speak WP [“without prejudice”] if you like.”

Again, Mr. Neidle declined. He said, “Please note I will not accept without prejudice correspondence.”

Mr. Neidle said this because “without prejudice” communications have a special status in civil litigation. In essence, they cannot be put before the court. Mr. Neidle did not want to cede his right to put anything Mr. Hurst said before the court. “If you are not prepared to say it out loud,” Mr. Neidle implied, “do not say it.”

This did not deter Mr. Hurst. He composed a snippy letter he will have since come to regret.

Snippy letters are part of the stock-in-trade of civil litigation. Much of it is resolved without resort to much else. Most people back down at the first missive they receive on law firm-headed notepaper.

Mr. Neidle is not most people. He is not the backing-down type. Law firm-headed notepaper was not going to cow him: his own name had been on law firm-headed notepaper for many years. He does not frighten easily. He likes a scrap. Mr. Hurst ought really to have known this, from a casual read of the papers. It seems he did not.

Mr. Hurst emailed his snippy letter to Mr. Neidle. It was ill-judged in a few respects, but in one especially: it claimed to be “without prejudice and confidential”.

It said:

It is up to you whether you respond to this email but you are not entitled to publish it or refer to it other than for the purposes of seeking legal advice. That would be a serious matter as you know. We recommend that you seek advice from libel lawyer if you have not done so already.

There was no attempt to settle the dispute at all. Mr. Hurst’s letter was not an attempt to stave off litigation, but a veiled threat to embark on it:

Should you not retract your allegation of lies today, we will write to you more fully on an open basis on Monday.

In the meantime, our client reserves all of his rights, including to object to other false allegations that you have made.

I am available to discuss if you change your mind on having a phone call. That could well save time and expense on both sides.

Even at this stage, Mr. Hurst held out hope that a phone call might de-escalate things. He hoped in vain.

Mr. Neidle gave Mr. Hurst a polite version of what we might call the “Pressdram Salute”.2 He published Mr. Hurst’s “without prejudice and confidential” letter and, not long afterward, referred Mr. Hurst to the Solicitors Regulation Authority, complaining that Mr Hurst’s use of the “without prejudice” label amounted to, or somehow hinted at, a “strategic lawsuit against public participation”.

So-called “SLAPPs”, in which the moneyed and powerful use the legal system to stifle fair enquiry into matters of general public interest, have become a bane of public life in the UK. The SRA has been on the warpath against them. It saw in Mr. Neidle just such a “public participant” and, in Mr. Hurst’s letter, an intolerable attempt to muzzle him on Mr. Zahawi’s behalf. It began an investigation that culminated, 18 months later — no-one could accuse it of precipitate action — in a referral to the Solicitors Disciplinary Tribunal, on the grounds that Mr. Hurst was engaged in an illegitimate SLAPP.

Before we get to that, it is worth recounting what happened in the meantime, without the SRA’s intervention.

Firstly, Mr. Neidle did not retract any of his allegations, and in fact doubled down on them.

Secondly, Mr. Zahawi did not exercise any of his “reserved rights”. None of the veiled threats in Mr. Hurst’s letter came to pass.

To the contrary, in January 2023, Mr. Zahawi was reported to have paid a penalty to HMRC. Shortly after that the Prime Minister’s Independent Adviser on Ministers’ Interests identified that he had breached the ministerial code seven times. The Prime Minister sacked Mr. Zahawi from his post as Chancellor of the Exchequer the same month. Within a year, in the face of growing opposition from his own constituency party, he announced he would not stand in the 2024 General Election.

That is to say, thanks in significant part to his misconceived attempt to limit Mr. Neidle’s “public participation” Mr. Zahawi’s political career spectacularly imploded.

We should take heart from this outcome. It feels like a system working well: hubris is rewarded with nemesis. The cosmos has delivered its own savage justice. In its perverse way, a prominent politician’s freedom to detonate his own reputation seems a positive constitutional safeguard. It is not clear what further action is needed.

The Solicitors Regulation Authority did not agree. It came for Mr. Hurst. Two days after the Chancellor’s sacking, the SRA referred him to the Solicitors Disciplinary Tribunal. It accused him of breaching SRA guidance by improperly labelling his correspondence “without prejudice”, “confidential” and “not for publication”, when the conditions justifying those labels were unfulfilled.

This seems a rather timid complaint. SRA guidance cautions solicitors not to intimidate or mislead third parties, and to take particular care with the vulnerable or unrepresented, but the SRA’s focus on these formal indicators, rather than the substantive intimidations in the body of the letter, seems rather, well, formalistic.

It may be because it seemed a “slam dunk” contravention of SRA guidelines. They specifically call the formal labels out:

One way this can happen in this context is by labelling or marking correspondence ‘not for publication’, ‘strictly private and confidential’ and/or ‘without prejudice’ when the conditions for using those terms are not fulfilled.

In any case the SDT heard the matter in December 2024 and, in May the following year, handed down its decision. It agreed that Mr. Hurst had acted improperly and fined him £50,000.

Mr. Hurst appealed. In January 2026 the administrative decision of the High Court upheld his appeal and overturned the SDT’s finding.

In light of the practical resolution of events — Mr. Hurst’s client torching his own political career — and the curiously formalistic approach to the disciplinary breach, this seems the correct outcome.

Without prejudice

“Without prejudice” is, in JC’s view, a silly frippery of the civil courts. In seeking to imbue a kind of legal privilege to bona fide settlement offers — a privilege they absolutely do not need — the courts have evolved a fiddly, confusing and self-contradictory cranny of procedural jurisprudence. Rather than regarding them simple markers of a constructive approach to dispute resolution, the court is expected to pretend that formal settlement overtures do not exist. They acquire an odd, mystical, Schrodinger’s cat-type status, though, because — sometimes — they can be presented when it comes to arguing about costs.

But that’s as may be, however: the “without prejudice” rules exist and we are stuck with them. So is Mr. Hurst.

A key plank in the SRA’s argument was that Mr. Hurst’s communication was no kind of settlement offer, and that therefore labelling it “without prejudice” was improper and intimidating. This idea is implicit in its guidance, quoted above.

But this gets things exactly backward: a “without prejudice” label (for whatever reason it is applied!) is the opposite of threatening: it signals a settlement offer. One should be overjoyed to receive a without prejudice letter. The “prejudice” it seeks to avoid is to the interests of the sender. Without prejudice is defensive, not intimidatory. It is a white flag, not a black one.

That, indeed, is why the courts developed its silly jurisprudence: to spare the sender’s blushes: to prevent disclosure before court a document which on its face speaks to its author’s weakness.

“Without prejudice” seeks to avoid misconstrual as a concession of weakness from the sender, not aggression. The SRA guidance in this regard seems off-base.

The SRA asserted Mr. Hurst’s communication was no kind of settlement offer. It may not have been, but it was — arguably — an attempt to resolve the matter: a “confidential and genuine attempt to resolve a dispute with you before further damage is caused”, in Mr. Hursts’ own prose.

On the face of it, the email was plainly and indisputably aimed at securing the retraction of the allegations of lying as an alternative to the possibility of defamation litigation.

Attempts to resolve disputes by demanding retraction are not really what the “without prejudice” rule is about, though — where is the potential prejudice in that? — and, in any case, not being allowed to show your letter to a judge if you are sued is hardly as grievous an intimidation as, well, actually being sued — and, ipso facto, there can be nothing wrong with a citizen its exercising legal rights to do that. Which, in any case, Mr. Zahawi did not ultimately do.

Mr. Hurst’s real mistake was to confuse his labels. “Without prejudice” does not come into it. What he really wanted to say — and did also say — was that Mr. Neidle must be silent about his letter: that it was protected by legal obligations of confidentiality.

Unfortunately for his client, Mr. Hurst was wrong about this, too.

Confidentiality

Every commercial lawyer knows a bit about confidentiality. You can hardly miss it: every commercial relationship — every exploratory discussion, however offhand — will be prefaced with an NDA.

All NDAs say the same few essential, uncontroversial things. There are about five main points. Everyone knows them. No-one argues about them. But most NDAs also try to crowbar in a couple of inessential, stupid and outrageous things. These are less predictable, but come from a stable roster of about ten inessential, stupid or outrageous commercial positions that are commonly said in the context of an NDA negotiation.

Lawyers, since time immemorial, have argued these same theoretically, but not practically, risky elements. This is a sociological conundrum in need of explanation: no-one enjoys doing NDAs, they serve no particular purpose beyond stating the obvious, no-one ever sues on them, but no-one has quite yet figured how not to do them.

It is a small mystery that no standard conceptualisation of how one should behave when collaborating has emerged, but that is another story. Good people have, with only moderate success, tried.

Generally, if you want to tell someone a secret, and want them not to blab about it, you need a contract.3

Still, there is a sense that lawyers are somehow different. We have a vague sense that if a solicitor writes to us on notepaper headed “confidential” then this must mean something. It does work the other way: what you tell your solicitor she must keep confidential: what she tells you, you need not. All the more so, a third party’s solicitor.

Our vague sense here, that is to say, is wrong. The SRA is sufficiently worried about it to issue guidance and — in this case — to launch disciplinary proceedings about it. This seems uncalled-for to me: it is one thing to wrongly threaten people to keep quiet. It is another thing to try, wrongly, to use the justice system to make them be quiet. Mr. Hurst did not do the second thing. There was no strategic lawsuit.

In any case, the lesson for Mr. Hurst, his client and the rest of us is this: the way to enforce confidentiality is, first and foremost, to keep your own mouth shut, rather than blabbing your innermost thoughts to unencumbered members of the general public. If you do, you really have only yourself to blame. Especially if you blab to a member of the general public as joyfully unencumbered as Mr. Neidle.

The High Court ruling

Mr. Neidle is disappointed about the court outcome, but really has no need to be. As the celebrated non-case of Arkell v Pressdram ably illustrates, commercial litigators write clumsy letters from time to time. We should expect the odd mis-step, but calling Matron every time a litigation lawyer gets over the front of his skis will have its own chilling effect on legal practice. And after all, if this level of misstep deserves SDT censure, especially given its ultimate outcome — if anyone here has a grievance, it is Mr. Zahawi, who might still have his seat had Mr. Hurst given him more forthright advice — then we should expect a lot more commercial litigators in the village stocks.

Mr. Hurst’s letter was silly. He should not have sent it. But it had none of its intended effects. Quite the opposite: there was no litigation, Osborne Clark quickly de-escalated and, in due course, the aggrieved Chancellor was drummed from office, partly because of his unsatisfactory tax affairs. Mr. Neidle was entirely vindicated and his reputation accordingly burnished.

We may summon a pained expression, but it is hard to see a need for further action against Osborne Clark or Mr. Hurst.

In the worlds before Monkey, primal chaos reigned.
Heaven sought order — but
The phoenix can fly only when its feathers are grown.
The four worlds formed again and yet again
As endless aeons wheeled and passed.
Time and the pure essences of heaven,
The moisture of the Earth, the powers of the sun and the moon
All worked upon a certain rock, old as creation, and it became
Magically fertile.
That first egg was named, “Thought”.
Tathagata Buddha, the Father Buddha, said:
“With our thoughts we make the world.”
Elemental forces caused the egg to hatch.
From it then came a stone monkey.
The nature of Monkey was —
Irrepressible.

— David Weir, Monkey 1978

As JC starts to overhaul the CSA Owners’ manuals I thought it might be nice to take a step back and look at the deep background to collateral as we glom it today. The road is long, and it has its roots in custom and practice in the industrial revolution. There is deep mythology in play, too. I know this because I made it up myself.

I was prompted to embark on this by the question:

“Why is collateral pledged under New York law CSAs while it is title transferred under English Law ones?”

Like so many of the mystic principles of the law, younglings are told this at an impressionable age, expected to absorb it, take it as read, and thereafter not ask impertinent questions about it.

JC’s dismal career trajectory might have something to do with asking questions that were impertinent — or stupid — in the supervising partner’s eyes there is little difference. In any case, I asked myself this question and — well you know me, readers — I went and fell right down a rabbit hole, didn’t I?

So here is the JC’s deep backgrounder on collateral, security and the role they play in mitigating credit risk and financing costs of lending and financing in modern markets, and why English law variation margin arrangements tend to be by title transfer, and New York ones by pledge.

Where the fossil record is incomplete — or I can’t be bothered looking into it — I have followed the time-tested JC tactic of making it up out of whole cloth. This is my truth. Buckle in!

Security & collateral. Credit & funding

This is a story about two pairs of concepts: “security” vs. “collateral” and “credit” vs. “funding”. These pairs relate to the business of lending and subtly different, financing. In their way, they help to distinguish between “lending” and “financing”. “Lending” and “financing” is another pair of conjoined, but independent, concepts. It is profound, and resists frontal assault. We can attack it through these proxies.

Security vs. collateral

The first pair is “security” and “collateral”. Herewith the first JC invention: a clean distinction between them. For the purposes of this essay, and perhaps only for the purposes of this essay:

Security is an immaterial legal right—a mortgage, charge, lien, an equitable interest.

Collateral is physical possession of a material thing—an asset, delivered to a creditor’s order for safekeeping.

You may not find it in Black’s Law Dictionary, but it is a practical distinction. Lawyers tend to use the concepts interchangeably: they fulfil similar roles when it comes to mitigating credit risk, but as we will see, not when it comes to funding.

Mainly, lawyers understand credit risk better than they do funding, because credit is the risk something might in the future go wrong, and that is a commercial lawyer’s main preoccupation. But funding is no less — nay, in the round, more — important. But we will get to that.

Now, there are collateral arrangements, security arrangements, and those that are both. I wanted to highlight a term here that captures either legal theoretical interests, whether or not also involving possession, and title transfer collateral interests that necessarily do but, as best as I can tell, there isn’t one.

I thought it might be “encumbrance”, but that implies a security interest, as does “surety”. I tried “posted”, but that conveys the transfer of possession. The commodities people have a concept of “performance assurance”, but that is too wide. Might this be a rare justification for and/or?

I thought that was annoying for a moment but, maybe it is the point. Collateral and security are quite distinct things. They can be, but (in the UK at least) are not often seen in the same room together.

You can have a security interest without any collateral (e.g., an assignment by way of security over contractual rights) and you can have a collateral arrangement without a formal security interest (e.g., a title transfer credit support arrangement). And you can have both. The classic case is the lien.

TL;DR: Security depends on legal magic to work. Collateral doesn’t.

So, that is the first pair of concepts. Security: immaterial rights. Collateral: stuff.

Credit vs. funding

The second pair is “credit risk” and “funding”.

Credit

From early in our careers we learn that, when it comes to handing money over to strangers, credit risk is a lender’s most obvious concern. Even lawyers understand it instinctively: will the borrowers be able repay? What are my weapons if they cannot?

Where a lender has collateral, there is little fuss. She holds it. She can sell it, claim what’s owed and give whatever’s left back. Other creditors can squabble over that to their hearts’ content. Our heroic lender is away, Scot-free.

Where the lender has only security, she is still okay: she can jump the unsecured creditors in the queue and seize secured assets — whereupon they become like collateral, so she can sell them and account for the profits — but to do that she must take formal legal steps, which require a court’s help and are easy to muff up. There is always the risk of challenge by other creditors.

If we invert the old saw Security is one tenth of the law. Possession, is the rest.1

Another difference between security and collateral is who has the use of the assets in the mean time?

The lender holds collateral assets. The borrower gives them up at the outset.

The borrower holds secured assets.2 The borrower keeps possession, but is restricted in what it can do. The lender has no right to intervene unless and until it is entitled to “enforce” its security. But this is an action of last resort, taken only with heavy heart and when all hope is lost. Everyone — borrower and lender alike — is fervent in their hope they this day never comes.

Usually, it never does: a bankruptcy is a remote possibility: a “tail event”. it happens rarely. But it is catastrophic when it does. Security arrangements where the borrower gets to keep its asset are therefore contingencies: forms of insurance a lender puts in place to guard against extreme events. Collateral arrangements, where the borrower collateralises day one, are not.

Another difference — a corollary to the above — is the depth of credit mitigation. The “credit value” of identified collateral is inherently limited to its liquidation value: once it is gone, it is gone. Hence, collateralised obligations tend to be subject to a haircut, regularly “marked to market” and exchanged to ensure there is always a buffer to cover the debt after liquidation. By contrast, a security right against a person is usually unlimited, to the value of the debt, against the person who grants it. You can pursue the guarantor to bankruptcy, if need be, to recover a beneficiary’s debt.3

On the other hand, “enforcing” against collateral is dead easy: you just sell it. No particular ceremony, though you must be carefully to achieve a fair price in the market. The more liquid your collateral, the easier that is to monitor. But enforcing security interests is elaborate, involves lawyers, courts and frequently bankruptcy administrators.

So credit is the assessment of a borrower’s likelihood of repay her debt. “Credit risk mitigation” is anything a lender does to improve that likelihood in the event of the borrower’s failure. Security interests and collateral arrangements both mitigate credit risk.

Funding

Funding is the business of finding the money with which a lender makes a loan in the first place. Lending institutions need reliable funding sources: those may be their own customer deposits,4 separate banking facilities, or medium term note and commercial paper programmes and the bank’s repo and securities lending arrangements, whereby it “lends out” its inventory of securities held for investment, as hedges and as collateral in connection with its customer trading business.

This unglamorous but important business — making sure there is enough money available to lend, and at good rates, to whoever wants to borrow — falls to the bank’s treasury department. Wherever it comes from, money — “funding” — comes at the cost of the interest the bank must pay on it. A bank will do whatever it can to reduce its “cost of funding” and broaden its sources of funding.

A day one cost

Unlike credit risks, funding costs are remote contingency that everyone hopes will never happen. They are a fundamental input cost to the business of providing loans. Optimising funding costs can dramatically boost a bank’s overall performance. Getting it wrong can, in rare cases, be catastrophic — the classic example is Silicon Valley Bank — but in any case, managing funding is not a “once in a blue moon”, tail-risk sort of thing. It matters on every loan on every day.

The imperatives of funding optimisation, therefore, have quite different implications for the kind of security or collateral involved.

Though collateral and security interests both address the credit risk, only possessory collateral is any use in managing its funding costs.

Security ⇒ credit.
Collateral ⇒ funding.

Formal security arrangements like charges, mortgages, debentures and informal ones like liens give the lender confidence it will be repaid, but they don’t help fund lender.5 Having confidence your debt will be repaid does not raise the money needed to lend it in the first place.

It seems obvious and usually, would go without saying: the reason borrowers come to banks is because they need money and don’t have it.

Some borrowers do have non-cash assets they do not for the time being need. Especially financial counterparties like investment funds. They tend to be flush with portfolios of investment securities that they have bought and from which they expect to earn a return. That return is a function of time, and while that time passes, those investment securities are just loafing about not really doing anything. A resourceful treasury manager will try to use these securities as collateral. She will deliver these, bodily, to her lender in return for a more competitive loan rate. The lender can afford a more competitive loan rate because that collateral is a potential source of funding.

The lender can monetise the collateral by selling it or onwards “re-pledging” it into the market to generate the money needed for the loan, on condition that it will buy it back, or unwind the pledge, when the loan has been repaid and the borrower wants its collateral returned.

We can see that financial instruments pledged as collateral with this freedom to “reuse” them do help fund the lender’s loan portfolio.

The history of financial collateral is, essentially, a shift from arrangements providing only credit protection to arrangements providing both credit protection and funding optimisation. This required the development of technology to support it. It is, in a way, the history of securities financing.

It starts a long way back, before the dawn of the Age of Swaps. We will go there, next time.

From all that terror teaches,
From lies of tongue and pen,
From all the easy speeches
That comfort cruel men,
From sale and profanation
Of honour and the sword,
From sleep and from damnation,
Deliver us, good Lord!

G. K. Chesterton, O God of Earth and Altar

A mystery persists. What is it about this waiver of privilege that so fixates everyone?

It is plain, under current rules, Ms. Letby must waive privilege on the topic of fresh evidence, chiefly to determine whether this new material really is “fresh evidence” and, if not, why not, and why was it not presented when it could have been at trial?

Ms. Letby’s new barrister, Mr. McDonald, is hardly shrinking violet. On most topics, he won’t be quiet. On this one, he is curiously reticent. It is a formal step, but he does not seem to have taken it. (We don’t know this, of course, but it is consistent with his public statements). It may be he has not yet been asked. But as the law stands, the appeal cannot get much further without it. If, as he says, Ms. Letby is innocent, there shouldn’t be anything to lose.

Should there?

The apparent hold-up alerts prosecution supporters — who are prone to this sort of thing — to the smell of a rat. Aha: the defence is hiding something.

The privilege question brings together three large perplexities of this confounding case. They go along way to explaining why it is so controversial:

1. The missing defence evidence: If the prosecution evidence really was as flimsy as the “Letbyists“ say, why on Earth did Ms. Letby’s defence not present evidence to contradict it?

2. The copious trial: If the prosecution really was a farce, how on Earth, after ten months of eviscerating cross-examination, objection and legal submission, did the jury convict?

3. The privilege question: On the other hand, if Ms. Letby really is innocent — if this really is an epochal miscarriage of justice, then what does she have to lose from waiving her privilege?

The innocent have nothing to hide

“The innocent,” they murmur conspiratorially, “have nothing to hide.”

From the outset, prosecution supporters — let’s call them “guilters” — have bridled at the very idea anyone might doubt Ms.Letby’s guilt. But, to their ongoing, suppurating chagrin they cannot produce a gotcha: there is no simple swingeing juridical sword that can slay this heretical campaign for once and all.

What don’t you understand? She was tried and found guilty.

Their mood has only darkened as the public debate as developed. In the town square, at least, the miscarriage campaign has only gained momentum. Every new turn seems to support it. The guilters’ ramparts continue to erode.

“But,” they like to say, “in the town square, talk is cheap. Talk in a criminal trial is not.”

This is right. Criminal trials are filtered, chaperoned and climate-controlled. Careless talk is not allowed. Every utterance is frisked. Every action must conform to common law principles honed over centuries with the single goal of isolating truth and reasonable inference from the “easy speeches that comfort cruel men” — just the sort of carry-on you will hear in the town square.

The trial verdict thereby acquires a mystical status of higher truth. It is all that matters. It cannot be impeached by scurrilous tittle tattle in the taverns and bars — the kind of thing you are reading now.

In this oasis of probity, after time and weighty consideration, a jury of twelve ordinary citizens found Ms. Letby guilty. What later discussion happens outside the marketplace — the hoary banter amongst squabbling fishmongers — is of no moment.

Barristers are uncommonly fond of this view. Especially senior ones. But you can hold it for only so long: experience shows the courts can and do get things badly wrong. And when they do, they are notoriously slow to acknowledge it. Outrageously so. And when they do finally see the light, their change of heart is not, generally, occasioned by their own introspection. Rather, it arises because people outside the sanctuary — squabbling fishmongers in the town square, if you like — make an unholy racket about it.

Unholy. I use that word advisedly. Often, until their change of heart, the legal system regards such efforts with contempt.

But the “marketplace of ideas”, with all its squabbling fishmongers, is a good leveller: after all, cruel men can make easy speeches from either side of the aisle.^[1]

What is remarkable about the public debate, given the resounding nature of the convictions, has been its imbalance. It has been one-way traffic. In eighteen months, the guilters, though resolute in giving no quarter, have barely fired a shot. All they have is the trial. That is their citadel. But try as they might, they cannot turn up any incriminating revealers beyond it. Nor can they find anyone with germane expertise to corroborate the expert opinions the crown presented at trial.

If Ms. Letby really is guilty, this, too, is a deep mystery.

All the more surprising, because those finicky rules of criminal procedure are designed in large part to protect defendants: to prevent unfairly prejudicial inferences being drawn about the accused in front of a biddable jury.

But now the jury has done its job and been sent home, there ought to be plenty of prejudicial inferences that, unbound by the court’s careful rules, guilters can lob about on social media. But — judging by the feeble dreck they do come up with — there don’t seem to be. As a result, public debate has been a piecemeal demolition of the crown’s case.

And nor has it been just we legion of fishmongers and poundshop Poirots. In 2024, no less august an outlet than the New Yorker published 13,000 words questioning statistical misconceptions in the trial. Since then, a procession of world-renowned experts, from places as far-flung as Canada and New Zealand have intervened, unbidden, to support the defence.

What would prompt recognised experts, apparently without recompense, to stick their necks out in support of a convicted multiple-murderer of premature infants?

The best the guilters can come up with is that these experts are dupes — victims of, or complicit in — an “innocence fraud”. (This is a form of psychological mass manipulation they appear to have made up.)

Capsizing the Bayesians

Those speaking for Ms. Letby keep dragging the discussion back to probabilities. In the guilters’ eyes they ignore the “hard facts” of Ms. Letby’s trial and conviction.

And, they remind us, none of these newly-arrived experts witnessed anything. (In fairness, nor did the prosecution experts who gave evidence at trial, a fact the guilters gloss over.) So these defence experts can only present their knowledge abstractly: they can say, “ah, yes, but the collapses could have been caused by this”; “It’s a lot more likely to have been that”, but they cannot tell us what actually happened.

Guilters have found the hypothetical nature of these contributions exasperating.

“What does it matter that she wasn’t likely to do it if we know she actually did it?”

This rhetorical is a neat lay summary of Bayes’ theorem, by the way: the unspoken answer is, “it doesn’t matter a bit: if she did it, the improbability of that fact in the abstract is entirely irrelevant.”

But — unless one is prepared to accept the trial verdict without question, and “Letbyists” aren’t — we don’t know she actually did it. The case is maddeningly lacking in concrete evidence. So, probabilities do matter.

As the debate has moved on, those defence hypotheticals, those appeals to abstract probabilities over “proven facts” — the very lack of proven facts to settle things over way or another — has stubbornly remained, while the several circumstantial limbs of the prosecution case that grounded the original convictions have, one by one, given way.

Her “confessions”, taken out of context from a morass of stream-of-consciousness scribblings that also asserted her innocence and victimisation, were nothing of the kind. The handover notes found under her bed weren’t “serial killer trophies” after all: by and large, they had nothing to do with the charges. The prosecution expert had his paltry understanding of air embolus symptoms, cribbed from a general and long out-of-date paper, perfectly backwards. The police misread door-swipe data immediately before significant events to have Ms. Letby entering the ward rather than, as was in fact the case, exiting it. Rather a consultant fortuitously discovering Ms. Letby standing inertly over a desaturating infant “virtually red handed”, the consultant’s own contemporaneous notes, not disclosed at trial, suggest Ms. Letby called him to the emergency. The insulin immunoassay equipment used to test samples was unreliable, known to throw out errors of exactly the magnitude of the readings cited by the crown as “smoking gun” evidence of Ms. Letby’s malicious intervention, and the tests were not rerun or corroborated.

Not just one or two of the prosecution planks have been undermined: all of them have. There is a better, more likely, explanation for every one of the prosecution’s key contentions.

These are not trifling issues. Even taken separately, they would throw significant doubt on the verdict. Together, they suggest the trial was fundamentally, fatally flawed.

The tide of public opinion has, accordingly, turned. The dwindling band of defiant guilters hold out hope for a clinching fact that would torpedo all this confounded hypothesising. To reiterate: all abstract “prior” probabilities, however compelling, can be overturned by “posterior” fact: just one fact could do it, but the longer things drag on—the more everyone combs through the details, the less likely such it is such a fact would have lain undiscovered. We’ve been through the trial and eighteen months of fractious banter. The police have investigated tirelessly for a decade now: they are still going, they say, debating further charges. But nothing.

Privilege as the final frontier

There is one last place no-one has checked. It is a place unusually likely to contain “killer facts”, what’s more: it is just the sort of place you might find a clincher. The record of private, candid communications between Ms. Letby and her criminal lawyers. This is, as we know, guarded by the sacred constitutional dragons of privilege. Ordinarily, they are impregnable.

But here, by dint of a quirk of recent case law — arguably a bad statement of law, but let’s park that, because, for now, it remains good law — if Mr. McDonald wants to proceed, he must stand his dragons down.

Guilters, therefore, turn their focus on Mr. McDonald. He seems to baulk at the very thought of waiving privilege. They are attuned to smelling rats and, in Ms. Letby’s strange hesitance to give way on this privilege question — and, really, that means her advisers’ reluctance^[2] — think they may at last be onto one. What is he hiding?

This, perhaps more than anything, gives guilters hope they will be finally vindicated. Mr. McDonald is sitting on a devastating “posterior” fact: a clincher no-one else knows that, being privileged, is impervious to enquiry, but which, if it got out, would blow all the defence experts’ careful hypotheticals out of the water, for once and for all putting Ms. Letby’s guilt beyond doubt.

Common law rules require appellants with new legal advisers who wish to introduce fresh evidence on appeal to waive privilege as far as is needed to satisfy section 23(2)(d) of the Criminal Appeals Act 1968.

That is to help satisfy the Court that there is indeed a reasonable explanation for the appellant’s failure to adduce the evidence at trial.

Ms Letby’s trial counsel, Mr. Myers, must file what is called a “Gogana statement”^[3] attesting to the evidence he had and did not have, what steps he took to find it and why, if it was available, he did not use it.

These are all questions of great interest in this case.

The “thin end of the wedge” argument

Mr. McDonald’s publicly expressed view on why he is reluctant to waive privilege is different. It was reported in the Guernsey Press — why not? — as follows:

If privilege is waived, they’re going to have access to every single conversation she’s ever had with her lawyers. You know what they did with her Facebook searches, and with a text message conversation she had with another doctor, Can you imagine if they had access to every single conversation that she’s ever had with her lawyers, all there in front of them, how that could be used against her, if there’s an inconsistency in something she said four years ago and has changed her mind in whatever way it may be? That’s your area of concern when it comes to waiving legal privilege? ^[4]

In my view, for the little it is worth, this does not really hold water. Courts do not play fast and loose with privilege. The waiver would be limited to Mr Myers’ “Gogana statement”.

All other communication with lawyers— everything except the specific question of what evidence was available and what good it could do her case — would remain privileged.

So what are some other reasons to hesitate?

The trial is that air-conditioned crucible of truth, remember: that is where opposing counsel can, within carefully developed rules, pick holes in the defence evidence. Or blow holes in it. The defence’s reasoning for not subjecting its experts to such an interrogation might be revealing.

Mr. Myers might have told his client any of the following things:

“This evidence is flimsy, and prosecution cross-examination could undermine it.”

The “it’s feeble evidence” argument

In their book, Unmasking Lucy Letby, Judith Moritz and Greg Coffey lean towards the first alternative: the defence did not lead evidence because what they had was flimsy, and vulnerable to cross-examination:

Although Dewi Evans and Sandie Bohin did most of the heavy lifting in the prosecution’s scientific arguments, these other experts made their own contributions to specific parts of the prosecution case. That raises an obvious question: why did Letby’s defence not call their own army of experts — their own pathologist, their own radiologist, their own insulin expert, and so on? Did her defence team fail to seek out their own experts? Or — as in the case of Mike Hall — did Letby herself choose not to call any experts, and if she didn’t why didn’t she?

I don’t doubt this is right, but nor does it really have much bearing on whether to waive privilege.

The proposition here is that the defence went to get rebutting evidence at the time, and what they received from the experts they spoke to was not enormously encouraging. Given the nature of the prosecution evidence — itself speculative and hypothetical in nature — this is not surprising: no credible expert is going to refuse to rule out a remote possibility, so the defence evidence might be taken in a way to affirm the prosecution case, especially when framed that way by prosecution cross-examination and closing submissions. If you can’t land a knockout punch on the prosecution case, why open yourself up for a counter-jab?

Experts consulted at the time may have been unenthusiastic about the prospect of going to extraordinary lengths to defend someone already portrayed in the public sphere as a likely monster — even radiologists are human, after all.

But that was then. Public opinion has shifted. The panel of international experts now have been a good deal more categorical and have identified further nuances and medical subtleties that were not addressed at trial. They could have been addressed at trial, perhaps, but they were not. The Court may take something of a dim view here — but on the other hand, if a potential expert witness is not volunteering subtle and nuanced information, it is a bit unreasonable to expect a non-specialist barrister to recognise it: the very reason we have expert witnesses in the first place is because these things are not intuitive or obvious to the jury. Nor would they necessarily be to a criminal barrister.

The Court has an option here: if it is not minded to hear the evidence, it has a justification for not doing so. If it is, it has the discretion to get over the hump. For all its formal insistence on analytical rules, the “temper of the times” will have a bearing here, and Mr. McDonald’s efforts to change that temper may be telling.

In any case, this does not feel like a clinching argument to resist waiving privilege. The Court’s supposition will be that this evidence should have been presented at the time, and anything Mr. McDonald can present to explain why it was not must help — or elucidate his case — in some way.

The “it undermines the defence case somehow” argument

The second has been aired in the town square by barristers of some renown. It is not that the evidence itself is wrong, but it kicks away vital support struts for other aspects of her account of events. But since Ms. Letby’s defence has been “Beyond knowing it was nothing to do with me, I do not know what happened”, and since the evidence in question would be presented not to support her concrete account of events — she hasn’t given one — but to undermine a tendentious hypothetical theory advanced by the prosecution, it is hard to see what damage this evidence, or any evidence, could do, beyond just seeming a bit feeble. That alternative accounts conflict with each other does not matter when they are hypotheticals. What matters is that they, in the alternative, conflict with the prosecution’s case theory.

The “I know she’s guilty” argument

There is a third possibility. This one is viable — highly unlikely, but certainly not impossible. Perhaps trial counsel Mr. Myers was unable to lead this evidence, even though it is true and correct in itself, because doing so would mislead the Court. A barrister’s ultimate duty, over and above even his duty of privacy is to the Court.

How could true evidence mislead the Court?

Well, remember our Bayesian inferences and the probability conundrum we discussed earlier. There are background, or “prior” probabilities from which inference is possible in the absence of anything better — “statistically, what was the resting likelihood of murder, compared with some other benign explanation for the collapses?” — and then there are posterior probabilities — is there anything better that might adjust those underlying base rates? “What specific information is there that Ms. Letby did — or did not — cause the collapses that would undermine the “prior” base rate assessment?”

If the defence knows of “killer” posterior facts — excuse the pun — that would render abstract hypotheticals irrelevant, then it would be highly misleading to present that abstract hypothetical evidence. It would be a serious breach of professional obligations.

Mr. McDonald’s “fresh evidence” is hypothetical. It is all to the effect that “there is a far more likely explanation than murder.”

It would be quite irrelevant if, for example, Ms. Letby had made it clear to her counsel that she had, in actual fact, attacked the infants. If she had told her lawyers:

“Between these four walls, you should know that I

So great is the Court’s reverence for form over substance, that it will tolerate this absurd hypothetical. (I do not for a moment think this happened, but it could.) Such a defendant could ask her counsel to take her case.

But counsel would be bound by the overriding duty to the Court. He cannot mislead the court, but nor can he let the court in on what Ms. Letby has said. He can say to her:

“I can defend you, but only by putting the Crown to proof. The Crown, and not you, has the burden of proving the charges. If it cannot, you will walk free. I can make them prove their case, and I can do my best to challenge their evidence and counter their arguments. But I cannot make a positive case for you. I cannot present alternative hypotheticals that I know to be untrue.”

Wrap up

If this is right then the guilters have their smoking gun. As long as Mr. McDonald has being cagey about it, they will hang on to this conviction: at this point it is pretty much all they have. It explains the mystery missing defence evidence, and it explains the hesitation over waiving privilege now. This is the “killer fact” that could emerge from even a narrow waiver of privilege.

Still, it is extremely unlikely for a number of reasons, the main one being that if it was inappropriate to lead evidence about misleading priors then, then it would be no less problematic to lead it now. If the defence knows Ms. Letby did these acts it cannot lead evidence supporting the proposition she might not have. But clearly Mr. McDonald does want to introduce it. He plainly sees it as his best and most powerful tactic. He cannot regard it as misleading.

And let us not forget his predecessor Mr. Myers went into trial fully intending to present defence evidence — as is evidenced by Ms. Moritz investigative journalism — which is why this is even a question. Mr. Myers submitted witness briefs at a pretrial conference of expert witnesses. He had his own expert, Dr. Hall attend trial throughout and seems to have made decision not to go with it at the last minute. There are sound reasons for not leading underwhelming evidence that may have done more harm than good.

And, Mr. Myers tried to introduce Dr. Lee’s evidence about air embolism in an appeal. This is not consistent with his knowledge of Ms. Letby’s malicious action. He would not have done that — he would hardly have mounted an appeal at all — if Ms. Letby had been convicted of offences for which he knew she was guilty.

But if the real reason for withholding was that the trial witnesses weren’t coming up to brief, why the reluctance to waive privilege? Why not say that? Things have changed. The evidence available now is much stronger. There is an army of leading academics behind it.

What is most baffling is the “PR” value is all of this. Mr. McDonald has, to date, been canny with his PR. But he is losing on this one. The speculation that he is hiding something — and guilters are making a meal of it — is corrosive. The longer McDonald delays, the more that speculation hardens into its own narrative: “The defence is hiding something.”

Nobody — but Mr. McDonald and his team — knows. Only Mr. McDonald can shut this debate down.

After all: if it were true — if Ms. Letby had somehow copped to these awful crimes — then we should all want to know that. Gulling scores of distinguished experts into unwittingly defending a confessed murderer would be grotesque. It would be an outrage. The Court deserves to know. The public should know. This debate should, either way, be ended.

But if it’s not true — and I don’t believe it is — Mr. McDonald needs urgently to take back control of the narrative and quell this speculation. He can do that by doing exactly what the law requires: advising Ms. Letby to waive privilege on the narrow question, have Mr. Myers file his Gogana statement, and put the matter to bed.

This is going to be quite the epistolic journey. Like a Dickens novel designed for people with no taste in literature and an unusually high threshold for pain. I have started to refresh the CSA pages. As I go I am going to put out newsletters and podcasts. Here is the first once.

Premium subscribers: the premium version of the podcast covers all the economy material, too. You don’t need to — but are fully welcome to! — listen to them both.

Eco-subscribers: for the price of half a pint of alcohol-free beer at the JC’s local every week, you too could have all the extra jokes, analysis and nasal mumbling that the Premium subscribers get. Sign up to the premium substack, and you get automatic access to the premium JC

The preamble to ISDA’s CSA

On preambles, weapons in Russian plays, etc.

The “preamble” is the throat-clearing passage of a commercial legal document: the scene-setter that puts you in the right place, the right frame of mind, and gives you a non-spoiling sense of what is coming. It is the warm-up question on Millionaire, designed to settle an anxious contestant down, so you might expect there to be little more to say about it.

Now occasionally a preamble might introduce a key fact into the narrative — a kind of “Chekhov’s gun” that the reader must mark, bear in mind, make mental note of, and prepare for its discharge in the third act.

The preamble to ISDA’s suite of Credit Support Annexes is no exception. There are not one, but now seven: the first was released to the Americans in 1994, a couple followed for the Brits in 1995, and four more came with the algal bloom of margin regulation in the latter half of the 2010s.

The different CSA varieties have different preambles casually mentioning different firing irons fixed to the wall over the fireplace. So what is all that about, then?

Credit Support Document or Transaction?

The 1994 NY law CSA declares itself to be:

...a Credit Support Document under this Agreement

while the 1995 English law CSA that followed hard on its heels reports that the credit support arrangements it documents:

...constitute a Transaction (for which this Annex constitutes the Confirmation).

Isn’t that odd? In the ISDA universe, “Transactions” and “Credit Support Documents” are mutually exclusive things: one is an integral exchance done under the ISDA Master Agreement, the other an independent covenant that stands apart from the Aïessdiyé. Can the ’Squad, in their Wording, have meant them to be different?^[1]

Well, roll forward a brace of decades and see what has changed. It is the post-apocalyptic year of our lord 2016. The kind warm glow of ISDA watches over the planet’s “safe, effcient markets”. The CSA form has been updated for the new regulatory world — but the, hark! The same dissonance!

The 2016 English law VM CSA, too, is a “Transaction” while its American brother the 2016 ISDA VM NY CSA is still a “Credit Support Document”! This cannot be — and not is it — an accident.

Now, English lawyers like to collateralise by title transfer, and Americans by pledge. The reasons are deep and somewhat interesting — there are some essays about it in the premium content — but in any weather this leads to some profound conceptual differences between the forms of CSA, even if the practical differences are minimal.

Title transfer CSAs are Transactions

Since collateral passes under title transfer CSAs by title transfer, it is not a security arrangement as such: rather, the parties agree to transfer collateral to each other outright, with no expectations beyond the recipient’s conditional obligation to return something economically equivalent when trading circumstances require it. This return obligation is a debt claim against the recipient for payment of an equivalent asset and not any kind of bailment, custody arrangement or ownership right in the asset originally posted.

Indeed, it resembles — is characterised as — an odd, highly personalised, self-referencing derivative Transaction.

Security interest CSAs are Credit Support Documents

Because they are traditional security arrangements, the security interest CSAs are characterised as “Credit Support Documents” and not “Transactions” under the ISDA Master Agreement.

So a title transfer CSA works by eliminating the out-of-the-money’s indebtedness by creating an equal offsetting indebtedness which may, if push really comes to shove, be netted down to mostly nothing.

A security interest CSA, by contrast, grants accepts some collateral and takes a traditional security interest over it as a surety for the indebtedness comprising that ISDA Exposure. That surety is a different covenant. It does not affect the quantum of the obligations under the ISDA: it comes into play only once they have not been honoured.

These are theoretical, and not practical differences. In practical fact, the arrangements are identical. Still, this is magical, bamboozling stuff — deep ISDA lore — even though, at least where rehypothecation is allowed — and it almost always is — it makes no real difference, to the parties whether the collateral is pledged or title-transferred, because from the moment it is reused, the pledgor has only a “credit claim” against the secured party for its return.

Credit support generally

Credit support is designed to mitigate the frightful credit risks the parties present to each other by obliging them regularly to “cash up” their net Exposure.

It should go without saying, but let’s say it: at any time, on a net basis, only one party can have an Exposure to the other. What with Independent Amounts — more of a vogue back in the 1990s in the ancient CSAs, more frowned on in the regulatory VM world of the mid 21st century — you could have both parties holding the other’s collateral, but variation margin, reflecting the actual mark-to-market value of actual transactions, could only be pointing in one direction at a time.

“Credit support” transferred under a CSA is designed to offset, as closely as possible, the value of that overall “Exposure”: what the “out-of-the-money” party would owe the in-the-money party were all Transactions terminated and the ISDA closed out on any given day.

The differences betwixt, and the impact of, regulatory margin

Thanks to the global financial crisis and the subsequent move towards regulatory margin there are now, as I mentioned, six theoretically “live” versions of the CSA. They are as follows:

The 1994 and 1995 versions may still kick around in name, but will have been heavily modified to comply with Reg Margin requirements. The main ones are the 2018 Regulatory VM CSAs — these tend now to be cash-only, zero-threshold, single-currency affairs. The Regulatory IM CSAs are a fact of life, if your portfolio is big enough to be in scope, but these are generally less operationally troublesome, though structurally complex. Most of the JC coverage will focus on the variation margin CSAs, therefore.

Prime brokerage

There is one corner of the market where CSA arrangements still differ a bit, and that is the Prime Brokerage world, where a customer will have a margin loan arrangement, stock lending, custody and cash accounts, and the broker will “net margin” the customer across its whole portfolio. There will still be VM CSAs, but they do quite a lot less lifting.

There is a whole different part of this wiki devoted to that business. See prime brokerage.

We will carry on with a deeper look at the theory and the practical differences below.

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Triago: There! That! Didst thou see ’t?
The card-sharp’s fumbling misdirect?
That tell-tale grin or worldly wink that
Cracks heav’n apart and for a twinkling
Throws rude light upon perfidious conjury!
Spy the dark-clad stage boy! How he flies —
Yet bolts a trice too late to beat the curtain’s rise.

Büchstein, Die Schweizer Heulsuse

Happy new year

I am very consc…

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This is a little different that the usual JC fare, and in lieu of any strengths plays to my weaknesses, which is the ability to get utterly sidetracked by the simplest questions.

On a train up to see my daughter Antagonista I happened across U2’s album The Unforgettable Fire. A guilty, embarrassing pleasure, but halfway though the six-minute, two-chord epic Bad it struck me what a magnificently great song, and performance it is, and that called to mind U2’s legendary, notorious performance of Bad — all ten minutes of it — at Live Aid.

I have a theory that Live Aid was a fundamental cultural touchpoint for people of my generation — that it changed the world in ways we do not often acknowledge – and this pulls on a few JC strings, and I started writing it up as a sort of appreciation of rock bands, guitar rock, digital delays, ambient music, plonkers, irony one of the great vocal performances — and and realised it would work much better as full audio surround sound experience.

So here it is. Hope you enjoy! If this goes well I might do a bit more of this sort of thing.

The original text — though it isn’t half as much fun — is here.

There is a Spotify playlist of the forty seven — FORTY SEVEN FOLKS — songs name-checked and sampled in this podcast!