European Derivatives Exhibition
June 12, 2003
to Financial News
June 23, 2003
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
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.
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."
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.
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.
history prompted Alan Greenspan, Chairman of the Federal Reserve
Board, to offer these congratulatory words to the IMM on its
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
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?
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."
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.
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.
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.
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.
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
in direct response to Warren Buffet’s concern, the chairman of
the Fed recently said the following:
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
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.
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.
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.
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.
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.
now the practice of deriding derivatives will be laid to rest....until,
that is, the next time!
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.
Comments by Federal Reserve Board Chairman Alan Greenspan on
the 30th Anniversary of the International Monetary
Market (IMM), May 16, 2002.
Wall Street Journal, lead editorial, March 11, 2003.
Remarks by Chairman Alan Greenspan, before the Futures Industry
Association, Boca Raton, Florida, March 19, 1999.
Remarks by Fed Chairman, Alan Greenspan, Board of Governors of
the Federal Reserve System, Conference on Bank Structure and
Competition, May 8, 2003.
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