DERIDING DERIVATIVES

13th Annual FOW
European Derivatives Exhibition
London, England
June 12, 2003

Submitted to Financial News
Op. Ed.
June 23, 2003

Deriding derivatives is a fashionable pastime. It is first cousin to defaming of futures. The ranks of practitioners are legion. They run the gamut from hit and run maligners—to professional bashers —to incessant Cassandras —and on occasion, to respected financial mavens.

Like, for instance, Warren Buffet. In a letter to shareholders, on or about March 3,2003, the chairman of Berkshire Hathaway declared that, "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." The Oracle of Omaha, is an American icon and arguably the greatest investor of all time. To say the least, Mr. Buffet’s derivatives derision belongs in the respected commentator class and cannot be ignored. But in doing so, Mr. Buffet joins the age-old tradition.

My first personal experience with this ritual was at the birth of financial futures at the International Monetary Market, the IMM, on the floor of the Chicago Mercantile Exchange, on May 16, 1972. As reported in the Wall Street Journal, a prominent New York banker declared that "it was ludicrous to think that foreign exchange can be entrusted to a bunch of pork belly crapshooters." A few years later, at the launch of our treasury bill market, the Economist compared the IMM to a bawdy house that was trying, "to make money by being more outrageous than its rivals." Not be left out, in 1982, Barron's called the IMM’s new stock index market, "Pin-Striped pork bellies."

Well, the new contracts were fair game. It was long ago, before anyone understood whether they had any value. To equate those early futures contracts with their present day counterparts, is like comparing Wernher von Braun’s 1958 Jupiter rocket with NASA’s latest Delta II marvel. In 1971, on the eve of the launch of financial futures, the transaction volume of futures markets in the U.S. was a scant 14.6 million contracts. They were predominantly in agricultural products. There were no foreign futures exchanges to speak of. A decade or so later, Nobel economist, Merton Miller, named financial futures "the most significant financial innovation of the last twenty years"¹ and offered this measuring guide: He said that the simple standard for judging whether a new product has increased social welfare is whether people were willing to pay their hard earned money for it.

By that standard, those scorned financial futures products proved their worth a gazillion times over. They propelled the Chicago Mercantile Exchange into first place in the United States with a 2002 record volume of 558 million contracts—predominantly in finance. They spawned financial futures exchanges in every corner of the globe—from Argentina to Australia, from Italy to India, from London to Kuala Lumpur. The combined global 2002 exchange volume of financial futures and options, an astounding 6.4 billion contracts, representing an unimaginable 441,000 % increase from the date of their birth. And that only represents about a third of the story. After the popularization of computer technology in the early 1980s, financial engineers, emulating what centralized futures exchanges in Chicago had wrought, applied their talents to devise a never-ending array of financial products for application in risk management, and made a Swap the watchword in the world of business.

That history prompted Alan Greenspan, Chairman of the Federal Reserve Board, to offer these congratulatory words to the IMM on its Thirtieth Anniversary:

The financial derivatives markets, which the IMM has played a critical role in developing, have significantly lowered the costs and expanded the opportunities for hedging risks that previously were not readily deflected. As a consequence, the financial system is more flexible and efficient than it was 30 years ago, and the economy itself may be more resilient to the real and financial shocks.²

A good deal of the credit must go to Merton Miller, Harry Markowitz and William F. Sharpe who won the 1990 Nobel Prize in economics for recognizing and heralding the value of derivatives in business application. Their pioneering work in the theory of financial economics ushered in the modern era of risk management which became the accepted standard worldwide. Naturally, their academic endorsement coupled with the overwhelming success of derivatives ended all skepticism and derision....NOT! Even before they could spend a penny of their Nobel award, derivatives began to be blamed for a long list of debacles: Procter & Gamble, Atlantic Richfield, Metallgesellschaft, Orange County, Barings Bank—not to mention, the ever popular Long Term Capital Markets, to name a few. LTCM even rekindled the much more serious question of whether derivatives pose the threat of systemic failure?

According to William Sharpe, this was predictable. In his Nobel lecture of December 7, 1990, he explained that "More than most sciences, economics not only analyzes reality, it also alters it. Theory leads to empiricism which changes behavior. Nowhere is this more evident than in financial economics." The past several decades, he noted, were marked by unprecedented innovation in financial instruments. "Given the bewildering pace of such innovation," he warned, "it is not surprising that some individuals and organization have at times found it difficult to fully understand the proper uses of some of the new instruments and procedures. Evidence abounds that those who fail to learn the principles of financial economics in more formal ways will do so through experience. Markets are effective although sometimes cruel teachers."

You bet! Life is rampant with risk—the marketplace, menacing and merciless. From the moment you rise till you fall asleep. From crossing the street to buying a house; from purchasing stock to instituting a vega-weighted time-spread. No magic formula exits to expunge the risk involved. There is no substitute for good judgment, professionalism or prudence; no short cut for education, reputation or discipline. The only riskless state is after you pass on—and no one can guarantee even that.

Warren Buffet is correct that derivatives can be dangerous and that their applications have at times been mismanaged. There can also be little argument over his contention that further mismanagement is inevitable. But most experts emphatically disagree with his view that such mismanagement will be catastrophic. The lessons of LTCM have been incorporated by academics and practitioners alike. The recent spate of disgraceful corporate scandals have made our financial system stronger. It all boils down to a question of the greater good to society and how effectively the risks associated with derivatives are managed. Derivatives, like automobiles, can be deadly weapons. Fatal accidents happen all the time, but no one suggests everyone stop driving. In every case where the use of derivatives went South there was first a human decision to go North, or East, or West. Yes, derivative management can go bad, but in the vast majority of cases where they went bad, a human being either didn’t understand the risk involved, took too much of it, did not properly manage it, committed a crime, or knowingly gambled—and lost.

Thus, while derivatives are no holy grail, neither can they be blamed for the lack of knowledge or insufficient risk controls of those who get burned by them. What derivatives are, the Wall Street Journal stated in its sharp editorial rebuttal to Buffet, "are little miracles of financial engineering."³ They are tools with which to manage risk exposure. And pursuant to Miller’s welfare gauge, of overwhelming value. Today, according to the latest BIS figures, outstanding notional value of Over the Counter derivatives reached $128 trillion in June of 2002. Add to that the value of open interest on centralized exchanges and you approach an outstanding notional total of nearly $200 trillion.

There is little mystery about it. We live in a highly complex and hazardous economic environment where information travels at Internet speed. We live in a world in which competition is intense and global, where interest rates, exchange rates, and other asset prices are volatile, and where dangers as well as opportunities rapidly appear and disappear on a constantly changing financial horizon. We live in a world where the possibility of any economic dislocation, the prospect for any change in value or price, the expectation of any alteration in national economic policies, whether it be the result of international turmoil or the consequence of domestic business disruptions, whether it be in finance or agriculture demands the means by which to limit the attendant risks or an opportunity to capture the perceived or real profit potential.

To manage these financial risks, the marketplace has turned to derivatives. The economic function of these instruments is to provide a safety-net based on benchmark groupings of inherent business exposures or to unbundle the risks involved into their basic components and transfer them to those most able and willing to assume and manage each component. Consequently, financial derivatives—both on centralized futures and options exchanges or customized in the OTC market—can be likened to a gigantic insurance company that allows financial market risks to be adjusted quickly, more precisely, and at lower cost than is possible with any other financial procedure. A process that has improved national productively growth and standards of living.⁴

Indeed, in direct response to Warren Buffet’s concern, the chairman of the Fed recently said the following:

The use of a growing array of derivatives and the related application of more sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries. Derivatives have permitted financial risks to be unbundled in ways that have facilitated both their measurement and their management.⁵

As a result, proclaimed the Fed chairman "not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient." He also made the telling assertion that the recent defaults of WorldCom and Enron as well as that of Argentina, represented the largest corporate and sovereign failures in world history and yet the fallout of these massive financial shocks "did not significantly impair the capital of any major financial intermediary."⁶ Even though, I might add, these defaults occurred at a time of a weakened US economy and amid unprecedented corporate scandals. All we can do is ponder the gravity of the fallout from such shocks had they occurred prior to the derivatives revolution. Compare, for instance, the fallout and duration from the US Savings & Loan scandal of the 1980s.

In fairness, I must stress that in voicing his concern, Warren Buffet most likely would distinguish between OTC derivatives and futures contracts on centralized exchanges. At the core of Mr Buffet’s criticism lies the fact that the collapse of Enron—aside from its illegal actions—demonstrated that manipulation of mark-to-market derivatives pricing can result in what he calls "mark-to-myth"reporting. His point is well taken that mark-to-modeling of exotic derivatives positions offers opportunities to cheat in valuations—and that there are motivations to so do. For many derivatives, the market is so thin that valuation models must be used and those models can contain a great amount of unwarranted optimism. Undeniably, there is an opportunity for traders to mark their distant positions to a "market" that makes them look good or that hides losses. Thus, we categorically agree with both Buffet’s and Greenspan’s assertion that full disclosure and transparency in financial reporting is critical in making the use of derivatives safer.

That is precisely where organized futures and options exchanges shine. Not only are disclosure and transparency the hallmarks of their transaction and clearing mechanisms, there can be no doubt about the integrity of their daily settlement procedures. Even in the most distant Eurodollar contract at the CME—priced ten years into the future—there exists a real price established every day in a notoriously open forum. No trader can fool his firms risk management system. No artificial pricing can occur. For within the structures of centralized exchanges—whether in their boisterous open-outcry pits or in the cyberspace of their electronic screens where trillions of dollars are transacted, cleared, and settled—derivatives markets flourish within as safe a financial design as the human mind can devise. At the core of these mechanisms lie some meticulously fashioned and highly sophisticated operations.

To be specific: The neutrality of their clearinghouses; their system of multilateral clearing and settlement—providing a central guarantee to every transaction and eliminating counterparty credit risk; their twice daily (at the CME) mark-to-market disciplines—eliminating accumulation of debt; their daily margining requirements; their full disclosure standards, transaction transparency, audit trail regimen, and financial surveillance procedures; and their regulatory oversight— the antithesis to the largely unregulated OTC market. These procedures and mechanisms represent a marvel of human thought and time-tested experience—the very essence of their default-free success. I believe, Warren Buffet would agree with these distinctions.

But whether on centralized exchanges or in the OTC markets, the Wall Street Journal had it right: The real miracles of derivatives is that they allow investors to separate and manage specific risks and hedge it, in varying degrees, by transferring it to investors who are more willing, or able, to assume it. Without this ability to off-load risk, capital markets would be smaller and less liquid because potential investors who are risk averse would cling to the sidelines. As risk is made liquid, transferred and shared among many investors, the damage from any disaster becomes muted. Consequently, derivatives have strengthened global financial markets by reducing the possibility of failure at one or more major institutions.⁷ And—contrary to the derision by skeptics—have made the financial world considerably safer.

Surely now the practice of deriding derivatives will be laid to rest....until, that is, the next time!

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(1) Merton H. Miller, Financial Innovation: The Last Twenty Years and the Next, Graduate School of Business, The University of Chicago, Selected Paper Number 63, May 1986.

(2) Comments by Federal Reserve Board Chairman Alan Greenspan on the 30^th Anniversary of the International Monetary Market (IMM), May 16, 2002.

(3) Wall Street Journal, lead editorial, March 11, 2003.

(4)  Remarks by Chairman Alan Greenspan, before the Futures Industry Association, Boca Raton, Florida, March 19, 1999.

(5) Remarks by Fed Chairman, Alan Greenspan, Board of Governors of the Federal Reserve System, Conference on Bank Structure and Competition, May 8, 2003.

(6)  Ibid.

(7)  WSJ Editorial.

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