More on Derivatives - Necessity vs. Novelty
First of all, I’d like to thank the folks over at the FT for taking my somewhat tough post concerning MSM’s depiction of Wall Street trading risk so seriously. They put up a post in their blog, Alphaville, about my emotional (passionate?) missive in Information Arbitrage yesterday. I had to crack up when their lead-in was as follows:
In the blogosphere, the mainstream media, the FT included, has got Information Arbitrage’s Roger Ehrenberg, the former head of Deutsche Bank’s fund of hedge funds and president of Monitor110, all hot under the collar.
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“A $120 million loss on a trading desk, unless the loss was the result of poor controls or a rogue trader, is neither a show stopper nor something that warrants intense eyebrow-raising and upset stomachs.”
Message received loud and clear, Roger.
Bottom line: they heard me. That’s pretty cool - thanks, Alphaville. I don’t know whether or not it was coincidence, but the FT had two very interesting stories yesterday on the issue of derivatives that I believe warrant discussion. But before that, let me tell you my view of the evolution of the derivatives marketplace since the early 1990’s.
My 2 Cent Perspective on Derivatives History
I think the early-mid 1990’s could be characterized as the wild, wild west period of the derivatives markets. A bit of a gold rush mentality prevailed across most asset classes. Interest rates were low, companies frequently viewed their Treasury operations as profit centers and people sold crazy, crazy instruments to banks. Sales of naked options - principally variations on interest rate puts. Leveraged derivatives (does anyone remember the LIBOR-cubed swaps?). Pure punts via “index amortizing swaps” calibrated to a particular rate view. Risky and massive mortgage books that served to underlie MBS pools. At the same time, banks built huge portfolios of complex correlation risks while the risk management systems themselves weren’t yet sufficiently evolved to deal with these mounting exposures. You can think of the risks inherent in this market environment as something akin to a Ferrari attempting to traverse the cobblestone streets of Rome at 140 mph. Someone is going to hit the wall. It was inevitable.
Then came the Fed’s 300 bps increase in rates starting in early 1994. The party was over, and the derivatives speculators (note that I use this word and not the word “hedgers”), in general, were caught off-guard. This includes both corporate sellers of volatility who were simply trying to collect premium they thought (and hoped) they wouldn’t give back (which they did, in spades) and trading desks that were also poorly positioned for the flattening yield curve environment. MBS buyers also got clobbered as duration was extended in a rising rate environment. And all of this happened in the face of one of the steepest yield curves in history, with short rates pegged at 3% and the long bond trading at 8%. Remember why a yield curve slopes upward? The interest rate market’s expection of higher future rates. Did this scare people? No way - sell forward optionality! Harness that steepness to collect premium today which hopefully won’t have to be paid back later. And this is why things got really ugly when the Fed took the punch bowl away.
First came the P&G/Bankers Trust debacle. A corporation taking a $200 million trading loss on a “hedge?” Sure, a “hedge” that had a duration of 125 years (which offsets precisely what exposure in the business?). Then Air Products. Then Gibson Greetings. And countless other corporations of scale who lost hundreds of millions of dollars when they had to mark these derivatives to market but who suffered in silence when the losses hit. And, of course, the corporations blamed the banks for fleecing them (which is a bunch of crap, to be sure, but hey, you gotta blame somebody other than yourself). Bottom line - a little bit of the luster came off of the derivatives market, but even if corporate use of these tools slowed during the 1994-1996 period, institutions and governments continued to use these tools in quantity.
As the late 1990s/early 2000s rolled around, there was a key theme that precipitated the exponential growth of the derivatives marketplace: the blurring of the lines between debt and equity. First the equity derivatives marketplace really exploded, with an amazing amount of innovation benefiting investors and issuers alike. Structured convertible bonds that lowered issuance costs for corporations, equity hedging strategies that created extremely flexible, cash-efficient share buyback programs, private convertible instruments to monetize appreciated stock positions, portable alpha strategies for pension funds, and on and on and on. At the same time, the concept of “capital structure arbitrage” was born, emerging from either the convertible trading desks or the credit trading operations of the large Wall Street firms. This strategy of trading the different strips of the capital structure was facilitated by an innovative but very straight-forward tool - the credit default swap (CDS). CDS allowed credit buyers and sellers to use derivatives in lieu of the actual instruments to create a position. It was this emergence that, to me, accelerated the blurring of distinction between debt and equity. Artificial barriers would no longer be tolerated. How can you optimize the trading of equity without taking advantage of the information and liquidity inherent in the debt? And this, in turn, set in motion the innovation we have continued to witness over the past five years.
CDS, LCDS, CBOs, CDOs, CLOs - these tools have emerged to help buyers and sellers get what they want, either in terms of risk transfer or portfolio return objectives. As these markets have grown they have become more standardized, and issues of weak documentation are being dealt with aggressively by Wall Street trading desks and their counterparties alike. I am sure, by now, you are completely nauseated by my little missive on derivatives history, but I have done this to prove a point - when instruments are created that generate real value, the markets explode. When they are mere gimmicks that fail to materially enhance one’s ability to either make money or manage risk, they falter. And it is here that I’d like to turn to the two stories in the FT.
When Derivatives are Necessary - A Market Emerges
Richard Beales’ article drives home the point that innovation has been rapid and has created real benefits, but not without some concerning arising from fears over how the markets will handle stress and unacceptable levels of undocumented trades:
The pace of financial innovation is quickening. Products that barely existed a few years ago are already multi-billion-dollar markets.
Derivatives and structured instruments have evolved particularly quickly across the capital markets, especially in the worlds of credit, equities and commodities.
Many of these innovations benefit the financial system because they help disperse risk more widely, analysts and regulators say. But there are concerns as they have come at a time of economic growth, low interest rates and low volatility.
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Other novel instruments are also designed to serve a practical purpose. Loan-only credit default swaps (LCDSs) allow lenders to hedge exposure by buying a type of insurance or protection against the borrower’s default – though they also allow hedge funds and others to take positions without owning the underlying debt.
The LCDS market is an offshoot of the still rapidly growing market for basic credit default swaps, the most common credit derivatives. While CDSs enable market participants to buy and sell protection against default on unsecured bonds, LCDSs are designed to track the credit of secured loans.
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Innovation brings challenges for regulators. In the credit derivatives world, US and European regulators have also had a hand in encouraging the finance industry to put its house in order. Last month was the anniversary of an initiative to clean up paperwork problems and increase automation in the industry.
The Federal Reserve Bank of New York, which hosted a meeting of 16 dealer banks and their regulators, welcomed progress in cleaning up the backlog, which a year earlier had been seen as a potential threat to the stability of the financial system.
But in a sign of the pace of innovation, the regulators’ attention is shifting to other parts of the derivatives world, such as equity derivatives.
“We look forward to seeing the industry improve the automation and standardisation of over-the-counter equity derivatives trading and reduce the current levels of unconfirmed trades,” said the New York Fed.
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Sure, when you are building a trillion dollar market there will be bumps in the road. But when you look at the ability for issuers and investors alike to:
- Benefit from enhanced liquidity;
- Transfer risk to those best able to absorb it; and
- Access a vehicle for taking a holistic view of the capital structure and to express a view in a variety of different manners and market
It is hard to underestimate the value of this innovation.
When Derivatives are a Novelty - The Market Flounders
Saskia Scholtes also had an interesting piece on the equity default swap (EDS) market, which has has languished since its development in 2003:
Of the many ideas thrown at the wall by investment banks eager to develop the latest must-do derivative, not all stick that well.
One product that appears to have been consigned to the derivatives larder for now is the equity default swap.
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Launched in 2003, when memories of the bursting stock market bubble were still painfully fresh, the concept was logical, say investors.
But equity market volatility has subsided and the attraction has waned. Protection against a fall in share prices is also easily achieved with a simple put option. The promised growth in EDS trading volumes may be on hold, at least until the next bear market.
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The idea was to allow banks and investors to fine-tune their positions further. But one credit hedge fund manager suggests that this added level of complexity may have been “one step too far” for broad-based market adoption.
The key take-away here is that innovation for innovation’s sake simply doesn’t work, even in the “arcane and esoteric” world (needless to say, I am being extremely sarcastic) of derivatives. The market knows what it needs, and when smart people come up with smart ideas there is rapid adoption followed by exponential growth. It is good to know that there is a self-policing mechanism in place called Mr. Market which makes sure necessary ideas are rewarded while others fall by the wayside. This is the way it should work, right?
