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DERIVATIVES
MARKETS:
YESTERDAY, TODAY, TOMORROW
Presented
at the 17th Annual International Organization of Securities
Commissions (IOSCO) Conference
Mexico
City, Mexico
October 27, 1993
In
1974 I participated in the proceedings before the U.S. Congress
that gave rise to the Commodity Futures Trading Commission (CFTC),
the primary regulator of futures markets in the United States.
I was then and remain today a supporter of this federal agency,
indeed, I was a leading proponent of the creation of the CFTC
and helped frame its structure. However, then as now, I was mindful
that every federal agency is, at best, a mixed blessing. For
while regulatory bodies are always created with the best of intentions
and can benefit the private sector, they inherently contain the
mechanisms with which to veer from their intended course and
become an impediment or even a destructive force.
Mindful
of this fact, I testified that the proposed legislation had within
it some onerous provisions that would allow the CFTC—wittingly
or not—to impede innovation. Specifically, I was referring to
the broad justification provisions that required a contract market
to prove the economic and public interest of a proposed futures
contract in order to receive federal approval. I brazenly argued
before Congress that, "Pioneerism needs no economic justification"—only
the market itself can provide such proof. In retrospect, I like
to believe that my testimony made a difference in the subsequent
application of the economic justification test by the CFTC. Indeed,
I doubt very much whether in 1972—before the demise of the fixed
exchange rate system of Bretton Woods—I could have proved there
was an economic or public need for a financial derivatives market
such as that represented by the foreign currency futures of the
International Monetary Market of the Chicago Mercantile Exchange
(CME).
Today,
a similar dilemma exists for the regulators of world markets
as they wrestle with the problems posed by modern financial markets
and present day innovations. Consequently, I welcome the opportunity
to address the members of IOSCO in order to caution and implore
that, in your desire to better world markets, you not inadvertently
make them worse. For you have it in your power to do both. It
cannot be overstated: In today's global economy—forged as a consequence
of technology and informational flows—market regulators as never
before face daunting tasks brimming with challenge and fraught
with danger.
The
world has changed substantially and dramatically since IOSCO
was formed in 1974. Indeed during the past two decades the transformations
our civilization has endured in science, technology, economics,
and politics nearly defy comprehension, and are of such magnitude
that they cannot be described in fewer than volumes of written
words. However, for the purposes of this conference, allow me
to extract the one over-riding principal that impacts those of
us in the markets: The world has confirmed that economic
and political freedom form the quintessential foundation for
economic success.
One
need only look at the miraculous metamorphosis occurring in Latin
America in the last decade to confirm this truth. The Latin transformation
was born out of the failed policies of the 1960s and 1970s which
are analogous to those attempted by the former Soviet Union—managed
national economic goals based on a structure of authoritarian
control over the population. In South America these policies
resulted in state owned industries and private monopolies, autarky
promoted by tariffs and export levies, huge external debt, archaic
financial concepts and laws, hyper-inflation, unstable currencies,
and undercapitalized markets. From that unfortunate history,
Latin America—from the Rio Grande to Tierra del Fuego—has begun
its difficult journey to democratic rule coupled with economic
reform based on a market driven order—Milton Friedman's prescription
for economic success.
The
results to date have been amazing: Elected governments have replaced
military dictators; old interventionist and protectionist policies
are being replaced with free trade concepts and agreements; managed
economics has been discarded in favor of market-driven principles;
state ownership is being replaced by privatization; and free
wheeling and unplanned economic policies have been abandoned
in favor of tight fiscal and monetary control. This positive
transformation of Latin American and Mexico, in particular, has
not been lost on the rest of the world. Indeed, if current trends
do not materially falter, as we enter the next century, this
vibrant and influential continent could very well take its proper
place among the economic powers of the new world order.
Thus,
the fundamental precepts of Adam Smith and Thomas Jefferson are
making their mark in Mexico as they are in every corner of the
globe.
Among
the important missions yet ahead for Mexico and Latin America
is the development of a broad and liquid futures market as well
as a sophisticated Over-the-Counter (OTC) derivatives market.
These markets are vital to the successful development of a market
economy. This represents a fundamental fact of economic life
in today's world, one that is imperative for every emerging economy—be
it in Latin America, Eastern Europe, or the Pacific Rim—to understand.
It is an equally essential principle for the members of IOSCO
to recognize.
We
live in a highly complex and dangerous economic environment,
one in which financial risks differ dramatically from those of
two decades ago. We live in a world in which competition is global,
financial volatility is constant and commonplace, and opportunities
rapidly appear and disappear on a constantly changing financial
horizon. We live in a world that demands products to protect
us from inherent financial risks, that demands cost-efficient
instruments to adjust portfolio exposure between securities and
cash, that pays a premium for credit-worthy mechanisms which
preserve credit lines, and that necessitates the expertise of
asset allocation and market-timing for sound money management.
In
today's world, the magic of technology has enabled us to divide
risk into its separate components and to devise instruments that
secure their values from other assets. We have evolved from simple
futures contracts in foreign exchange, eurodollars, and bonds,
to complex swaps and swaptions, strips and straps, collars and
floors. We have created and are continuing to create an endless
flow of products that are limited only by the needs of the participants
and the imagination of the financial engineers who invent them.
During
the first decade of derivatives use, dealers spent most of their
time with corporate treasurers who were almost exclusively interested
in reducing their exposure to interest-rate and currency risks.
Joe Argilagos, in charge of Merrill Lynch's Investor Service
Group, one of the earliest players in the investor derivatives,
states that during the eighties, "everybody was using their derivatives
capability to approach issuers and bring them a variety of alternatives
to access capital markets around the world."(1)
But
in the second decade of derivatives, innovation shifted from
the corporate to the investor side. "1992," says Mr. Argilagos, "was
the year when derivatives entered the mainstream for investors." He
explains that now you have to create "a conduit for investors
to access the markets, so that they could understand them and
manipulate them from their standpoint."
1992
was also the year when the derivatives market was discovered
by mutual funds and money managers trying to find ways to outperform
their competitors. It began, explains Jim McNulty, managing director
of Swiss Bank Corp., with the 1987 stock crash. Before then,
he stated, "almost no mutual fund fixed income managers were
using these structures. After the crash, there was an explosion
overnight in global bond funds as more people move out of the
stock market."(2)
The
investor side tends to drive you into a more structured and sophisticated
marketing effort, says Senior vice president of Natwest, Zahid
Ullah. "You need a wide product range, and you need to be in
exotic products." That to him means interest rate swaps, quantos,
yield-curve swaps, and LIBOR squared products. He also point
out that "the investor side is highly sensitive to the level
of rates and the shape of the curve. Dollar-based investors are
clamoring for high yields that don't generate any currency risks."(3)
Min
Hee Kim, a risk management vice president at Chemical Bank, points
out that "five years ago our traditional customer was a liability
manager who wanted to hedge against rising rates." Now, he states, "we're
dealing with a much more aggressive type of user," one who is
willing to increase risk, by exchanging some marginal unit of
risk for marginal extra return. For instance, Min Hee Kim, explains, "hedge
funds are using derivative products to create a risk not easily
available in the liquid markets. They might be looking for long-dated
options, or volatility risk not available on a futures exchange.(4)
The
foregoing private sector applications of derivatives represent
but a small sample of this exploding market. These products cover
the full gamut of financial risk and, I must add, the entire
alphabet from A to Z, for example:
From Agios,
(a bond's market value premium over par, expressed as percent)
to Z-bonds (an accrual tranche of a collateralized
mortgage obligation --usually one of the last segments to be
paid off in cash);
from Baseball
Options, (Options which become in, out, or explode
in an early exercise trigger when the exercise price is touched.
A baseball option: three touches of the outstrike and you are
out.) to You Choose Warrants (as apposed to
As-You-Like Warrants; A warrant with a provision permitting
the purchaser to designate it as either a call warrant or a
put warrant for a limited period.);
from Concertina
Swaps, (a variable notional principal swap that uses
the present value of an existing fixed-rate paying swap position
to increase an issuer's near term protection from high floating
rates) to Window Warrants (warrants which
can be exercised only during limited intervals in the life
of a host bond);
from Delta/Gamma
Hedges, (a risk offsetting position -- consisting
in part of short-term option contracts) to a Vertical
Bull Spread (Regardless of whether two puts or two
calls are used to create this option spread, the option purchased
has a lower strike than the option sold.);
from EYES,
(Equity Yield Enhancement Securities) to Up-and-In Options (path-dependent
options -- depends on whether they go up and in the strikes,
etc.);
from FANs,
(Fixed Assurance Notes), to Tail Hedging (adjusting
the number of futures contracts in a hedge position so that the
present market exposure of the hedge offsets the underlying exposure);
from GRIPs, (Guaranteed
Return on Investment Certificates) to Sandwich Spreads (akin
to Butterfly and Alligator spreads);
from Hindsight
Currency Options, (an option giving the buyer the
retroactive right to buy a currency at its low point or to
sell a currency at its high point within the option period)
to Rainbow Options (A call option with a payoff
based on the amount by which one of several underlying instruments
outperform the others.);
from Index
Allocated Principal Bonds, (a collateralized mortgage
obligation whose principal paydown is allocated according to
the value of some index) to Quasi-American Options (Like
the Bermuda option, it can be exercised on a number of predetermined
occasions.);
from Jellyrolls,
(a transaction in offsetting long and short synthetic stock positions
created from options with identical strike prices but different
expiration dates) to Poison Puts (a provision
of a bond or note which makes the instrument puttable to the
issuer following a change of control or a restructuring which
reduces the credit quality of the issue);
from Kickers,
(A sweetener; a right, warrant, or other low value security added
to a debt or stock offering to improve the market reception of
the entire issue) to One Touch Options (See
baseball option.);
from Ladder
Options, (an index or currency warrant or option that
provides an upward reset of its minimum payout when the underlying
touches or trades through certain threshold levels.) to Mini-Max
Floaters (a floating rate note with an embedded collar.).(5)
I
could go on and on.
We
live in a world where these instruments are used to protect against
changes in revenues and expenses resulting from exposure in interest
rates and exchange rates; where these instruments are used to
manage assets and liabilities; where these instruments are used
to enhance equity and fixed income portfolio performance; where
these instruments are used to protect against commodity price
rises or mortgage interest costs. As a consequence of their application,
risks are reduced and profit is increased over a wide sphere
of financial enterprise and in various ways—from businesses whose
efficiency is enhanced, to banks whose depositors and borrowers
are benefited; from investment managers who increase their performance
for clients to farmers who protect their crops; and from commercial
users of energy to retail users of mortgages.
We
must also not underestimate the role derivatives play in a macro-economic
sense, that is, their function in increasing the liquidity within
capital markets and in developing more efficient global intermediation
processes. By acting as a catalyst for the integration of various
markets, these instruments serve to foster rapid growth in international
trade and capital flows, allowing excess savings in one market
to be channelled into another. This process offers assistance
to emerging capital centers by funneling investment of savings
from mature industrialized countries into higher yielding opportunities
in developing nations. University of Chicago Professor Merton
Miller, the 1990 Nobel laureate in Economics, stressed this point
in his remarks last year to the Mexican Securities Market as
he urged Mexican authority to allow the creation of index derivatives
markets. "What you can essentially do with index futures," he
stated, "is to leave the physical assets in place while moving
their returns."
The
foregoing direct as well as tangential benefits of derivatives
markets to a market economy are unfortunately understood only
to a limited extent and with varying degrees of comprehension
among the governments of the world. They are frequently seen
as suspect and often misunderstood. The consequences of such
uneven awareness are unfortunate and can be dangerous. One need
only examine the recent effects to Japanese financial futures
markets to cite the deleterious consequences stemming from burdensome
regulations. Moreover, the difficulties faced by GATT and NAFTA
are salient examples where lack of comprehension and misinformation
can lead. It is a direction in opposition to the overriding needs
of today's interdependent world: Free trade, as well as coordination
and harmonization of the regulatory thicket effecting world markets.
The
value I have attributed to futures, options, and OTC derivatives
is not to be interpreted as a position against any form of regulation.
Derivative markets are not without risk, nor do we fully understand
all the nuances of the risks these instruments represent. Still,
my attitude is a far cry from those who have sounded the alarms
of panic, i.e. that "26-year-olds with computers are creating
financial hydrogen bombs."(6) I
also disagree with Bundasbank's recent warnings that the growth
of global derivatives markets could endanger the stability of
the world financial system.(7) Such
blanket indictments are far too simplistic. That is not to imply
that the world's financial system is not vulnerable to a major
shock; indeed, for many good reasons, I believe it is, but I
do not believe derivatives are the paramount cause for these
concerns. Instead, I fully endorse the recent "Group of Thirty
Study," chaired by Paul Volcker, former chairman of the Federal
Reserve Board, which concluded that:
"Derivatives
by their nature do not introduce risks of a fundamentally different
kind or of a greater scale than those already present in the
financial markets. Hence, systemic risks are not appreciably
aggravated, and supervisory concerns can be addressed with the
present regulatory structures and approaches."(8)
In
other words, derivatives do not result in the creation of a greater
quotient of risk than that which already exists in today's complex
financial environment. As Wayne Angell, U.S. Federal Reserve
Board governor, recently stated, "I consider derivatives
simply a product of the free market system."(9) I
also embrace the Group of Thirty Study's major recommendations
for regulators and legal authorities, to wit:
That
netting, or the multi-lateral closing out of unrealized gains
and loses in the event of a counterparty's default, is "the most
important means" of mitigating credit risk and systemic risk.
That
regulators identify and end legal and regulatory uncertainties
in the use of derivatives and the enforcement of netting and
derivatives contracts.
That
disadvantaged tax treatment of derivatives should be ended.
That
more uniform international accounting standards should be adopted.
On
the other hand, I do agree with the criticism of the Group of
30 study made by the Vice President of the Federal Reserve System's
Board of Governors, David W. Mullins, Jr., who said the study
lacked a rigorous examination of the appropriate capital levels
required to support the risk associated with derivatives. I would
also support the need for stricter accounting rules with respect
to these instruments. However, irrespective of regulations, I
have little doubt that the age of derivatives is upon us and
will continue to grow unabated.
Hopefully,
my remarks today will dispel some of the uncertainty about the
application of these financial instruments, serve to explain
their benefits to the underlying cash markets, and confirm their
constructive effects on a market economy. My mission here, however,
would be incomplete if I did not at least offer a glimpse of
what the markets of the future hold in store.
First,
the logical consequence of globalization and technology will
result in regional as well as global electronic markets that
either encompass the entire trading regime of a given exchange—such
as the Deutsche Terminbörse and NASDAQ—or interconnect to open-outcry
business hours, such as is the case of the CME and CBOT. In either
case there will be systems such as GLOBEX to extend the business
day and provide the competence of a complete 24-hour trading
mechanism. Not only is the handwriting on the wall, its appeal
nearly universal, its logic inescapable, but the world has been
advancing toward this objective since the onset of the technological
revolution.
Nor
are we finished with market innovation. Indeed we are poised
for yet another quantum technological leap into what is generally
known as Artificial Intelligence (AI). There are some
five basic approaches to this revolutionary trading concept,
each at a different stage of development:
Neural
Networks. A highly sophisticated trading system which
tries to mimic the human brain process and learns from its
mistakes. Modeled after the complex pathways of the human nervous
system, such nets search for patterns in vast streams
of data, learn from experience, and develop rules to recognize
these patterns.
Expert
Systems. These systems have, in fact, become the most
used AI systems in corporate America today. The technology
represents a computerized decision-making technique that embodies
knowledge gleaned from experts. These judgment programs remove
irrelevant trading ideas and accept the practical.
Genetic
Algorithms. A problem solving technique useful in
identifying and handling anomalies. As in a Darwinian universe
where only the fit survive, such software procedures reject
formulas that do not work, and steer the system in the right
direction, assuring that "only the good cells live."
Chaos
Theory. First introduced in 1975 by James Yorke and
made popular today by James Gleick, this theory holds that
seemingly random events, such as stock prices, actually have
patterns that computer programs can detect. Physicists and
mathematicians believe that, properly observed, apparently
random events like the movements of stock prices will show
themselves to be, if not predictable, then at least decipherable.
In other words, chaos programs will not necessarily show where
the market will go, but rather where it will not go.
Fractals:
Similar to the chaos theory, fractals attempt to explain "nonlinear" configurations
such as clouds or the movement of securities markets.
Like
alchemists of the medieval period trying to create gold from
lead, their modern-day equivalents apply state-of-the-art computer
technology to markets with a similar intent of turning their
trades into gold. While the application of this technology to
the markets is still in its infancy and while its ultimate value
is still unknown, rest assured it is on its way. Many
major American brokerage firms have spent hundreds of millions,
perhaps billions, of dollars on the development of this technology
because it offers such explosive growth potential. Much of their
work is top secret, "Those who know don't tell and those
who tell don't know." One cannot even begin to assess the
future regulatory problems posed by these systems, however you
can be certain that the members of IOSCO will have their hands
full.
Allow
me to conclude by offering this summation: In our global market
environment—an environment driven by instantaneous information
flows and sophisticated technology—financial risk is ubiquitous
and unending. Its management will continue to be the fundamental
goal of investors and money managers. Futures, options, and OTC
derivatives provide the ability to identify, price and transfer
existing risks. They are the premier tools of risk management
and are essential in a market economy. They will successfully
render this service only as long as world markets are permitted
to remain free, allowed to draw upon the ingenuity and creativity
of their participants, and so long as market regulations are
logical, practical, and harmonized across geographical borders.
In sorting out the difficult issues raised by the use of derivatives,
it is imperative that the world's regulators remember these vital
truths.
____________________
(1) Derivatives
Strategy, a publication specializing in surveying Derivatives
users and applications; Vol.2, No.1, July 5, 1993.
(2) Ibid.
(3) Ibid.
(4) Ibid.
(5) Dictionary
of Financial Risk Management, Probus Publishing Company, 1992,
Gary L. Gastineau, author; prepared and distributed by Swiss
Bank Corporation, New York Branch.
(6) Statement
attributed to Felix Rohatyn, senior partner at Lazard Freres & Co.,
as reported by Jonathan R. Laing, "The Next Meltdown," Barron's,
7 June, 1993.
(7) Financial
Times, October 22, 1993, p.17.
(8) Quoted
by Barry B. Burr, in an article titled, "Mark derivatives to
market study says," Pensions and Investments, 9 August
1993, p. 4.
(9) Ibid,
Financial Times
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