Derivatives: From innovation to exploitation… and back again?
Market veterans discuss how innovation in derivatives helped to open debt markets, hedge risk and tailor investments, before threatening the stability of the system during the global financial crisis of 2008. Can that early spirit of creativity be harnessed for today’s markets?
The use of a derivative agreement to mitigate risk can be traced back to around 1754BC, when the Code of Hammurabi was set in stone in Babylon.
That was 3,723 years before Euromoney began publication in 1969 and there were other examples of derivatives in the intervening period, from tulip futures in 17th century Amsterdam to the foundation of the Chicago Board of Trade as the first modern futures exchange in 1848 (which was also the year Karl Marx and Friedrich Engels published the Communist Manifesto).
The biggest transformation of finance by derivatives nevertheless took place during Euromoney’s first five decades.
Futures evolved beyond agricultural hedging in the 1970s with the development of listed interest rate, currency and commodity contracts.
However, it was a swap agreement between the World Bank and IBM in 1981 that heralded the birth of the over-the-counter (OTC) derivatives industry that would open global debt markets and offer new ways to hedge and assume risk. Salomon Brothers arranged for IBM to swap Swiss franc and Deutschemark debt with US dollar borrowings by the World Bank in a deal that was structured to circumvent restrictions on bond issuance.
As financial markets liberalized at different speeds in the 1980s, the ability to swap bond proceeds from fixed rate to floating and into other currencies became a key driver of a move towards more open markets.
“It was extraordinary and visionary, and suddenly you had global borrowing markets,” says Jerry del Missier, a former derivatives manager at Bankers Trust, who later became co-head of the investment bank and group chief operating officer at Barclays.
“That was a watershed for global capital flows and even for establishing global trade rules.”
Another watershed came with the establishment of the International Swap Dealers Association (Isda) in 1985, a trade group that later rebranded itself the International Swaps and Derivatives Association.
Documentation to standardize swap trades and speed settlement came with the development of the Isda master agreement in 1987; and legal clarity that netting of OTC contracts was enforceable led to spectacular growth in derivatives volumes.
“The business was able to grow to over $600 trillion of notional principal, which would have been difficult if not impossible in the absence of netting,” says Mark Brickell, a former JPMorgan derivatives banker and chairman of Isda from 1988 to 1992.
The accelerating pace of dealing drew the attention of the great and the good in finance, and in 1992 former Federal Reserve chairman Paul Volcker asked JPMorgan chief executive Dennis Weatherstone to form a committee of bankers and other experts from around the world to set out principles for derivatives.
“It was a decision by the leading market players to share best practices with the broader marketplace and began a trend of giving away intellectual property in exchange for a market that was less prone to pratfalls,” says Peter Hancock, who as head of the derivatives product group at JPMorgan helped to compose the Group of 30 derivatives report that was published in July 1993.
Hancock, who would later serve as chief financial officer of JPMorgan and after the 2008 financial crisis as chief executive of embattled insurer AIG, also highlights the way that shared technology helped to make derivatives markets more robust.
“Just before I left JPMorgan [in 2000 after the merger with Chase Manhattan] we created a technology standard – FpML – that provided an open source framework for disparate pricing models and back-office systems to talk to each other,” says Hancock. “That turned out to be a sound strategic decision that set a standard for much of the industry.”
But while the G30 report on derivatives practices in 1993 made the market less prone to pratfalls, it certainly did not prevent them. The following year an unexpected interest rate hike by the Federal Reserve prompted what became known as the bond market massacre, which in turn exposed how widely derivatives were used to add leverage – and how frequently end users and dealers alike struggled to appreciate their real risk exposure.
Bankers Trust, one of the most innovative dealers in derivatives, became a focus of litigation on charges of selling unsuitable deals. Clients including Procter & Gamble and Gibson Greetings accused Bankers Trust of putting together overly complex trades that left the corporations with confusing exposure to the rise in rates.
The contracts were certainly complicated – with shifting leverage at multiple barrier levels embedded – but from the perspective of the derivatives structuring experts this seemed to be a case of buyer beware.
“At Bankers there was a general disbelief that US corporates would not honour contracts – how could this be?” says del Missier. “The reality of course is that it’s not good business to be forced to sue your customers to get them to pay. It was a very painful lesson for those early innovators.”
It was a lesson that foreshadowed the problems that would develop as derivatives attracted employees who were typically more mathematically adept than both their customers and their peers in other parts of the bank. They quickly came to learn that structuring could facilitate highly lucrative arbitrage profits between different contract types, as well as across separate but related market instruments.
“I was very keen to start on the derivatives desk,” says del Missier. “It was a magnet for creative people, and we used to joke that BT attracted two types of people: they were very bright and unemployable elsewhere.”
The legal cases against Bankers Trust – complete with dealing room tapes of employees gloating at the margins they were extracting from ill-informed clients – set a template for the reputational scandals that would plague the derivatives markets during later financial crises.
The turbulence of 1994 did not derail the growth in derivatives volumes, however, and the industry was able to fend off attempts to increase regulation in important jurisdictions.
The US became a key battleground in the fight to resist greater oversight. Exchange executives from Chicago were keen to encourage regulators to clamp down on their rivals in OTC derivatives dealing by treating swaps in the same way as listed futures contracts.
OTC dealers found a crucial ally in the form of Wendy Lee Gramm, who was head of the Commodity Futures Trading Commission from 1988 to 1993 and could have pushed to extend her oversight to include swaps.
“The financial system was very fortunate that the chairman who arrived within a year of the proposal [to regulate swaps in the same way as futures] was Wendy Lee Gramm,” says Brickell. “She has great integrity, displayed here in her ability to separate the policy questions from the opportunity to expand an agency’s turf. It was remarkable.
“Now we were able to proceed under the supervision of the banking authorities. A great deal of innovation flourished in that environment and we were able to expand from interest rate and currency swaps into equity swaps and credit default swaps.
He adds: “If the business hadn’t grown as it did in the US, it would have been difficult for it to grow around the world.”
Difficult perhaps, but derivatives growth certainly was not reliant on developments in the US. OTC derivatives innovation was flourishing in London, where the market for swapped Eurobond debt was based, and legal setbacks did very little to stem the increase in swap and option activity.
Bankers were surprised when the UK courts ruled in 1991 that Hammersmith and Fulham Borough Council did not have the power to enter into interest rate swap contracts, invalidating existing contracts with banks and shutting down the market for derivatives trading by local authorities in the UK. But this had a minimal long-term effect on swap volumes.
And a market was developing that was almost entirely based in Europe and Asia, in the form of retail structured products.
“It wasn’t so much about customized swaps but about a lot of new retail clients you needed to involve,” says David Escoffier, former head of equities and derivatives, and later deputy head of global markets at Société Générale. “You needed massive computational power to follow and manage the new risks that were created, and new documentation and compliance was required to create handbooks for private clients.”
The market for retail structured products was initially equity based and made extensive use of listed contracts, avoiding the sharp divide between OTC and exchange-traded derivatives that was seen in the US.
“People forget too easily about the listed markets and in fact some of the more interesting players were bankers who became brokers,” says Escoffier.
The global nature of derivatives trading was underscored in the late 1990s, when the Asian currency crisis that started with the devaluation of the Thai baht in 1997 set off a series of chain events, some unfolding in unexpected ways.
Foreign exchange derivatives losses understandably accompanied the collapse in value of many Asian currencies. A trading hit that was estimated at around SFr600 million on equity derivatives correlation positions by UBS was more of a surprise. It later emerged that the equity derivatives group set up by Ramy Goldstein – a former Israeli soldier with an economics degree from Cambridge University and a PhD from Yale – had functioned with virtually complete autonomy within UBS.
Lessons about the risks of lax supervision of specialist trading units were not learned at UBS (which would later see more spectacular trading losses) or more widely.
The Asian currency crisis also fostered a dangerous sense of superiority on the other side of the world, at the Greenwich, Connecticut headquarters of hedge fund Long-Term Capital Management (LTCM).
The fund was set up in 1994 by John Meriwether, former head of bond arbitrage at Salomon Brothers, the firm that had arranged the first OTC debt swap in 1981. Meriwether hired other Salomon veterans and recruited as partners two academics – Robert Merton and Myron Scholes – who in 1997 were awarded the Nobel prize for economics in recognition of their work on options pricing.
In fact, 1997 was a good year for the whole LTCM team, as the fund managed to ride out the initial effects of the Asian crisis and report a healthy annual profit of 27%.
Derivatives put in the hands of people who think they are too smart and don’t fully understand the relevant risks can certainly lead to challenging situations - Jonathan Moulds
Markets remained turbulent in 1998, however, and when Russia defaulted on local currency debt in August a global flight to quality assets revealed the extent of LTCM’s leverage and a dangerous exposure to its derivatives positions on the part of the main Wall Street dealers.
LTCM had capital of $4.7 billion and debt of around $124 billion, for a leverage ratio of over 25 to 1. It also had over $1 trillion of notional derivatives exposure to Wall Street counterparties, mainly in the form of interest rate swaps, though with large accompanying equity derivatives positions.
Dealers were keen to secure commissions from LTCM, but they also took to copying its trades in misplaced reverence for the acumen of Meriwether and his team. This exacerbated the potential risks from its positions, which were mostly convergence trades designed to exploit supposedly temporary mismatches between similar instruments.
Many US banks were accordingly both counterparties to derivatives with LTCM and exposed to trades such as receiving fixed rate swap spreads against Treasuries at a time when gaps to benchmark yields in most markets were widening.
The Federal Reserve coordinated a bailout of LTCM by its main creditors in September 1998 and unwinding of its derivatives positions began. This was handled smoothly and the only big cost to an important dealer came in the form of a loss of almost $800 million for UBS, which had structured an investment of its own in LTCM in a way that left it with exposure to a put option on the fund.
In retrospect, the relative ease with which LTCM’s interest rate derivatives book was wound down gave stakeholders ranging from dealers to regulators a false confidence about their ability to manage a bigger crisis a decade later that would feature credit derivatives in a leading role.
“Derivatives put in the hands of people who think they are too smart and don’t fully understand the relevant risks can certainly lead to challenging situations,” says Jonathan Moulds, a former head of Bank of America Merrill Lynch Europe and chief operating officer of Barclays, who was involved in the LTCM unwind when he ran rates derivatives for Bank of America. “But although LTCM had significant risk concentration, I’d say they were easier risks to understand than in 2008.
“After 2000, the complexities multiplied; and when innovation gets ahead of itself and the pace outstrips market infrastructure development, there are real risks,” Moulds continues. “Given the limitations on the measurement of the risk concentration and the underlying structural complexity, some credit derivatives, particularly complex multi-tranched products, did pose a systemic risk given the size of the underlying market.”
Defining the extent to which credit derivatives caused or exacerbated the global financial crisis of 2008 is central to evaluating whether the popular conception of derivatives as uniquely threatening instruments is justified or not.
Warren Buffett famously described derivatives as financial weapons of mass destruction in 2003 – a phrase that has resonated ever since. The legendary investor actually has a long track record as a savvy user of derivatives and placed his biggest personal swap and option bets well after he made his ‘weapons of mass destruction’ quip.
Some market defenders maintain that derivative use had little bearing on what was effectively a US mortgage lending crisis that became global because of poor foreign investment choices.
“The problem in 2008 was systemic, and I believe that it occurred because many participants had become anaesthetized to the level of risk in mortgages and mortgage-backed securities,” says Brickell. “At the same time, public policy encouraged or directed that mortgages be supplied to borrowers whose ability to repay was increasingly marginal. The policy encouraged activity that distorted the measures of risk that the system was using to assess the likelihood of default.
“Suppose interest rate swaps or credit default swaps had never been invented, would we still have had a housing finance crisis? The answer is: absolutely,” Brickell adds. “Or suppose every American had made interest and principal payments on time and there were lots of interest rate and credit default swaps outstanding, would we have had a housing finance crisis? Absolutely not. The existence of those derivatives would not have caused the problem, the problem was largely in the housing sector and its public policy.”
Other market veterans concede that credit derivatives exacerbated the crisis by masking exposure.
“The ease with which you could access capital in a non-accountable way was clearly facilitated by the development of synthetic securitization and credit derivatives,” says del Missier. “That created a massive distortion in the underlying market.”
Suppose interest rate swaps or credit default swaps had never been invented, would we still have had a housing finance crisis? The answer is: absolutely - Mark Brickell, Clear Markets
A related problem was that credit derivatives in the form of synthetic collateralized debt obligations (CDOs) were mainly being used to assume mortgage risk, rather than to manage exposure by spreading risk.
“The application of CDOs to mortgages was a misuse of the tool,” says Hancock. “Corporate credit default swaps as originally designed used diversification as a tool – when you are adding your 2,000th Southern California mortgage, that is not what is happening. This was more of a systemic risk than an idiosyncratic risk that could be diversified.”
The market had also begun to attract a growing number of players who combined reckless position taking with cynicism about the possible side effects of their dealing. Banks paid bonuses mainly in cash at the time and annual compensation in a range between $10 million and $40 million was frequently seen for young dealers who had little experience of managing economic cycles.
“You had a bunch of people who knew the price of everything and the value of nothing,” says del Missier.
Examples of traders who fit that bill were easy to find in the approach to the 2008 crisis. At Morgan Stanley, Howie Hubler managed to lose an astonishing $9 billion in 2007 – before the crisis had picked up momentum – in a botched attempt to fund the purchase of some default swap protection by selling derivative exposure to better rated CDO tranches.
At Deutsche Bank, Greg Lippmann devoted great energy to finding counterparties to take the other side of his derivatives bets against the mortgage market, in the trades that led to his eventual portrayal by Ryan Gosling in the film based on the Michael Lewis book ‘The Big Short’.
Lippmann’s short trades provided a partial hedge for some Deutsche exposure, but CDO deals on other desks and trades by an internal credit derivatives hedge fund run by Boaz Weinstein resulted in billions of dollars in losses and in some cases created positions that took a decade to unwind.
At other firms, such as Merrill Lynch and UBS, bankers who were not derivatives experts relied on vague assumptions about effective hedging tactics in order to keep the CDO machine churning out deals in both cash and synthetic form, and in turn to keep bonuses flowing.
When global markets went into full meltdown in late 2008, derivatives of all types generated enormous losses, as did trades in traditional underlying assets. Basis relations between comparable instruments broke out of ranges that had come to seem standard because of limited data, partly due to the relative youth of some derivatives markets – and of the traders who dominated activity.
The losses by Weinstein’s fund within Deutsche resulted mainly from an unexpected failure by corporate default swap spreads to widen as fast as underlying bond spreads, for example.
The credit derivatives market suffered a body blow from the 2008 crisis. Notional credit default swaps outstanding fell from over $60 trillion at the end of 2007 to under $10 trillion a decade later, according to the Bank for International Settlements (BIS).
Much of this notional change was due to compression of existing deals and a shift toward clearing of some swaps after the crisis. There was also a sharp decline in trading activity and the use of default swaps for both hedging and risk assumption, however.
A recovery in confidence in the integrity of credit derivatives has also been hampered by recent examples of sharp dealing practices, such as the engineering of manufactured defaults designed to make swap positions pay off.
By contrast, the interest rate and equity derivatives markets bounced back quickly after 2008.
Some traders were able to exploit dealing opportunities in the immediate wake of the crisis. At Goldman Sachs two former interest rate swap traders – Ed Eisler and Ashok Varadhan – bet that rates would fall and stay low with trades such as going long Treasuries and futures and receiving fixed rate in swaps. That helped to produce $23 billion of fixed income revenue for Goldman in 2009, or more than half of the $45 billion generated by the whole firm that year.
Steps have also been taken to improve the safety of the core derivatives markets, such as a dramatic acceleration of a shift towards swap clearing that had begun before the 2008 crisis.
A BIS survey found, for example, that the portion of outstanding OTC derivatives that were cleared in June 2018 was 76% for interest rate derivatives and 54% for credit derivatives, and recent Isda calculations indicate higher cleared levels.
The BIS also noted that although the total for notional OTC derivatives had moved up to $595 trillion by the middle of last year, there was still a continuing fall in the gross market value of outstanding derivatives.
The BIS estimated the gross market value of OTC derivatives at $10 trillion in June 2018, which was down from $11 trillion at the end of 2017 and well below the peak of $35 trillion seen in 2008.
The BIS commended the effect of structural changes in driving this fall in gross market value, but there are still concerns about potential future problems for derivatives. Clearing houses themselves could pose a systemic risk by becoming too big to fail or taking on illiquid product exposure, for example.
The recent trend towards balkanization of markets also concerns some industry veterans.
“Some bigger issues have been created by a logical response to the crisis: greater subsidiarization and a retreat to national borders,” says del Missier. “I don’t think the trend towards globalization has been reversed, but we have certainly reached a plateau. Fragmentation and disintermediation continues, so we’ll see how that survives the next credit downturn.”
This creativity must continue to be used. In particular derivatives need to be applied to help in developmental finance – that is where the greatest needs are and where the money is currently not arriving - David Escoffier, Eighteen East Capital
Hancock thinks that reductions in gross market values should not serve as an excuse to ignore the overall amount of derivatives held by firms, especially big banks, which now have a greater share of dealing activity than they did before the crisis.
“People say that notional size doesn’t matter, but it is at least a starting point for sceptical stakeholders, whether they are shareholders or creditors,” Hancock says. “I am not sure that legal enforceability and political risk is getting the attention it deserves. Once you examine this and allocate more capital, the incentive to simplify grows.”
While core derivatives markets continue to reform and go electronic, there are still areas of potential innovation and expansion. The developing cryptocurrency markets could be viewed as a fertile opportunity for greater use of derivatives or an accident waiting to happen, depending on your perspective.
“There will be swaps and options on cryptocurrencies. There are already some derivatives in the form of exchange-traded futures,” says Brickell, who currently runs an electronic trading firm called Clear Markets.
Understandably, he thinks that derivatives market veterans can play a key role in this transition.
“We know how to build a market infrastructure and how important it is to have a sound infrastructure,” says Brickell. “That can be usefully applied in both spot and derivatives trading in the virtual currency sector.”
And the approach to problem solving that broadened access to debt for borrowers with the early swapped bonds could be channelled to improve financing in markets that remain underserved.
“This creativity must continue to be used,” says Escoffier, who is now a partner in Eighteen East Capital, a firm that aims to broaden the market for impact investing. “In particular, derivatives need to be applied to help in developmental finance – that is where the greatest needs are and where the money is currently not arriving.”
Derivatives may have played a leading role in the near-death experience for the modern financial system in 2008, a year before Euromoney turned 40, but the industry seems to be on a steadier footing as our 50th anniversary arrives.