Saturday, August 31, 2019

"The Early History of Regulatory Arbitrage" (How Put-Call Parity Helped Russell Sage Evade the Law And Become Rich)

Really rich.
Banker to the Vanderbilt's rich.
One of the richest Americans of all time rich.
Some day I'll get around to doing a post on Mr. Sage, he was an interesting person.
As was Olivia , Mrs. Sage, the distaff side of the family parity.

From the Oregon Law Review via the University of Pennsylvania Law School's Penn Law: Legal Scholarship Repository:

The Ancient Roots of Modern Financial Innovation: 
The Early History of RegulatoryArbitrage
Michael S. Knoll University of Pennsylvania Law School,

Recent years have seen an explosion in financial innovation.1The typical, contemporary American investor has access to financial services and instruments, such as exchange-traded stock funds (“ETFs”), Treasury inflation-protected securities (“TIPS”), and socially responsible index funds, that did not exist a generation ago.2 Less obvious, but of equal significance, are mortgage-backed securities and related developments that allow lenders to hedge their interest rate risk. These developments have made it possible for lenders to provide fixed-rate home mortgages at lower rates than otherwise possible during times of interest volatility.3 The impact of financial innovation has been even greater on Wall Street, which designs and sells innovative financial contracts and establishes the markets where these contracts trade, and Main Street, which has been an enthusiastic customer. Many large companies use credit derivatives, Eurobonds, interest-rate swaps, securitizations, and other recent financial innovations to reduce borrowing costs, hedge risk, increase earnings, reduce taxes, and speculate (sometimes with disastrous results) on price movements.4 The principle that underlies the rapid pace of financial innovation is that cash flows can be disaggregated and rebundled in almost unlimited combination.5 Not surprisingly, the rush of new financial products has created nightmares for regulators, who must fit new innovations into existing categories.6 The pressure is not incidental. The exploitation of regulatory inconsistencies is a major impetus for financial innovation.7Indeed, it might be the primary impetus.8 There is a strong incentive to innovate around prohibited or disadvantaged transactions. These innovations are commonly referred to as regulatory arbitrage.

Until recently, it was widely believed that most recent financial innovations were distinctly modern without direct antecedents.10 One reason for this view is that many financial innovations rely on option theory, which is of recent vintage11and mathematically sophisticated.12 In general, option theory is not accessible without training in advanced mathematics and many of its results are not readily intuitive. However, in a series of recent articles, leading finance experts have traced some recent innovationsmany of which are based on option theoryback to the innovations’ roots. This literature has succeeded in tracing some innovations back as far as four hundred years.13 This Article contributes to that literature by tracing the roots of one specific application of one well-known technique. The technique is put-call parity. The put-call parity theorem states that given any three of the four following financial instrumentsa zero-coupon bond, a share of stock, a call option (“call”) on the stock, and a put option (“put”) on the stockthe fourth instrument can be replicated.14 Thus, the theorem implies that any financial position that contains these assets can be constructed in at least two different ways. 

Professor Hans Stoll first described put-call parity in 1969. His article, “The Relation Between Put and Call Option Prices,”15 is deservedly a classic.16 It has produced an extensive academic literature and is the source of many important innovations.17 The application of put-call parity described in this Article is its use to avoid usury by synthesizing a loan. Although first described in the academic literature less than forty years ago, put-call parity is more intuitive than many ideas in option theory. Because it is so intuitive, the principle was being used before it was formally described:  
Put-call parity has been known for at least 100 years. Legend has it that the relationship was discovered by one Russell Sage, an extremely successful businessman in the 19th century. At one point, state usury laws prohibited him from making a high-interest-rate loan to a customer, so he bought stock in a publicly traded company from the customer at the market price. Simultaneously, he bought a put and wrote a call on the underlying stock at fictitious prices, where the customer took the opposite side of each transaction. This provided Mr. Sage with a guaranteed rate of return on his investment . . . . The customer, by always taking the opposite side, was effectively borrowing at this guaranteed rate. The prices of the options were set so that the rate of return to Mr. Sage was above what the usury laws allowed. Bank examiners did not prohibit this complex transaction, because they could not figure out that it was a loan in disguise.19
The thesis of this Article is that put-call parity has been used to engage in regulatory arbitrage for much longer than previously believed. This Article traces the use of put-call parity to evade usury restrictions back two thousand years.19 This Article also describes the important role put-call parity played in developing the modern mortgage. 

A. The Basic Instruments  
This Part describes the put-call parity theorem.20 The first step in illustrating the theorem is to describe the four financial instruments that are its components. These four instruments are a zero-coupon bond, a share of common stock (also called the underlying asset for a reason that will soon be apparent), a call on the stock, and a put on the stock. The call and the put both have exercise prices equal to the face value of the zero-coupon bond. The two options and the bond all mature on the same date. B. An Intuitive Proof of the Put-Call Parity Theorem21The put-call parity theorem states that the payoff from a portfolio consisting of one share of stock, and the right to sell that share (at date T for exercise price E), is equivalent to that from a portfolio consisting of a zero-coupon bond (that pays E at date T), and the right to buy one share of stock (at date T for exercise price E).22Using the convention that a subscript T indicates the payoff from holding an instrument at maturity and allowing S to denote the underlying stock, P a put on that stock and C a call, both with expiration date T and exercise price E, and E a zero-coupon bond that pays E at date T, then the put-call parity theorem....

See also at the SSRN: "Derivatives and Usury: The Role of Options in Transactions Used to Act in Fraud of the Law"
Date Written: May 17, 2015
The search for derivative contracts with complex features can also be explained as the market’s attempt to elude the restrictions imposed by the law on money loans. This is an undesirable effect of anti-usury rules. It can be added to the one mentioned by Montesquieu and Adam Smith, who pointed out that usury increases with the severity of the prohibition, since the lender indemnifies himself for the risk he runs of suffering the penalty.

In this paper we look at some of the ways in which derivative contracts can be used to circumvent anti-usury provisions and conceal money loans made at exorbitant rates.
After examining the simplest cases, we will consider more complex contracts, such as swaps with embedded options, which are often used in dealings between banks and municipalities. Our thesis is that, in all these cases, in order to detect usury, we have to calculate the contracts’ option-adjusted yields.
 SSRN download page