‘Derivatives business is full of beautiful lies’
‘As we know, these are the known knowns. There are things we know we
know. We also know there are known unknowns. That is to say we know
there are some things we do not know. But there are also unknown
unknowns, the ones we don’t know we don’t know.’ —Donald Rumsfeld,
when he was the US Secretary of Defence
Derivatives are at the heart of most financial crises that have
plagued banks and companies all across the world over the last three
decades. From small-scale industrialists of Tiruppur to the banks
lending to the subprime home loans market in the United States.
“Derivatives
business is filled with beautiful lies,” says Satyajit Das, the
internationally renowned expert on financial derivatives. He has had a
foot in both the sides of the derivatives equation, having worked for
banks (the “sell side”) such as the Commonwealth Bank of Australia,
Citicorp Investment Bank and Merrill Lynch and, as treasurer of the TNT
Group, for clients (the “buy side”). Das has authored several books on
derivatives including Traders, Guns & Money — Knowns and Unknowns
in the Dazzling World of Derivatives (2006, FT Pearson). He speaks
about the arcane world in an interview with Vivek Kaul.
How did financial derivatives become an important part of the financial system worldwide?
Derivatives
aren’t new. They evolved out of agricultural futures used for hedging
soft commodities for over 100 years. In the 1970s, the concept was
extended to financial commodities —- initially interest rates,
currencies, equities etc.
The original rationale was hedging —-
it’s what banks like to tell regulators and what regulators like to
hear. The real impetus to derivatives from the late 1980s onwards was
using derivatives to create and assume risk—- fundamentally the
opposite of what derivatives originally did. Investors were looking for
higher returns. So banks started to manufacture risks using derivative
technology.
They have many advantages —-cash settlement (you
don’t have to have a position in the underlying asset and volumes are
not constrained by available volumes in physical assets) and they are
off-balance sheet (leverage). Deregulated banks seeking to grow their
product range and profits found derivatives trading to be a new source
of revenues. All these factors combined over the last 20 years to help
derivatives grow into a $600 trillion market; around 10 times the world
GDP.
You say in your book Traders, Guns & Money… that the derivative business is filled with beautiful lies. Could you elaborate?
Beautiful
lies are the lies that we like to believe. We know they are not true
but everything makes us want to believe them. The derivatives business
is filled with ‘beautiful lies’ — for example, even the simple business
of hedging can be a beautiful lie.
Why is hedging a true lie?
Take the example of
an airline that locks in the price of its jet fuel over the next year.
You get the “illusion of certainty”. You can’t hedge without knowing
what is going to happen to oil prices. Locking the cost of oil through
forward contracts has a cost or a benefit, the difference between the
current price and the forward price.
If the oil price is
$100/barrel and the forward price is $110/barrel, then the cost of the
forward is $10/barrel. The oil price has to rise at least $10/barrel
before you gain. Does the forward guarantee certainty? The airline’s
cost of oil is fixed. But its problems are not over. Assume the airline
hedges but its competitors don’t.
If the oil price falls then
our airline’s cost of oil is fixed. But competitors benefit from lower
oil prices. What happens if the competitors cut fares? Oops! Our
airline is stuck with fixed oil costs so it can’t really afford to cut
prices. It can cut fares and bleed to death. It can keep fares high and
bleed to death. If it cuts fares then its revenue falls but its costs
stay the same. If it doesn’t cut fares, customers fly with competitors
with cheaper fares.
Hedging provides certainty —- of death. You
assume that the underlying exposure will be there. Suppose the airline
gets it routes —- the underlying exposure disappears but your hedge
remains. There have been quite a few notable hedging deaths over the
years. In the words of a famous surgeon: “The operation was a total
success but the patient died”.
You say lack of transparency lies at the heart of derivative sales. Why is that?
The
Chicago School and free market theocracy enshrined concepts such as
efficient markets, transparency and informational symmetry. A dealer
can’t get rich from that. If everybody understands the product and the
price is transparent then margins narrow. The game has always been to
complicate the structures making them less transparent to take
advantage of informational “asymmetry”.
Many clients do not
understand the structures or can’t value them. They may end up
overpaying for risk. Difficulties in valuation and assessing risk also
affect the banks. Traders need to convince risk managers there is no
risk and the product controllers that the profits they are showing are
correct. In this world, sales people lie to clients.
Traders
lie to sales people and to risk managers. Risk managers lie to the
people who think they run the place. The people who run the place lie
to shareholders and regulators. Investors and corporations generally
lie to themselves about their understanding of derivatives and why they
are using derivatives. The recent experience of Indian companies using
complex currency derivatives to hedge the rupee seems to be consistent
with the global experience.
What is the impact so-called ‘quants’ have had in popularising derivatives?
Financial
mathematics —- much of which is reasonably trivial — is used for
pricing, valuing and risk management of derivatives. Risk
quantification is based on the Gaussian distribution used by Markowitz.
Nicholas Nassim Taleb in The Black Swan argued that risk quantification
based on this approach has problems.
In the current crisis
people are talking about “one in ten thousand year events”! These seem
to occur every year. The concept of dynamic hedging that underlies the
Black-Scholes-Merton option-pricing framework allowed banks to trade
complex derivatives in the belief that they were hedged.
The models assume efficient markets, no liquidity constraints
and no jumps in asset prices. In practice, markets don’t behave that
way particularly in periods of stress. Long Term Capital Management
(where both Nobel Prize-winning economists Robert Merton and Myron
Scholes were partners) used both techniques with highly unsatisfactory
results.
Merton ironically articulated the problems of quant
models: “At times we can lose sight of the ultimate purpose of the
models when their mathematics become too interesting. The mathematics
of models can be applied precisely, but the models are not at all
precise in their application to the complex real world. Their accuracy
as useful approximations to that world varies significantly across time
and place. The models should be applied in practice only tentatively,
with careful assessment of their limitations in each approximation.”
The speech was less than a year before the collapse of Long Term
Capital Management.
Keynes (John Maynard, the economist) was
right when he observed: “Too large a proportion of recent mathematical
economics are concoctions, as imprecise as the initial assumption they
rest on, which allow the author to lose sight of the complexities and
interdependencies of the real world in a maze of pretentious and
unhelpful symbols.”
You have said fashion models and financial models are similar. Can you explain?
Fashion
models and financial models bear a similar relationship to the everyday
world. Fashion models are idealised concepts of male and female beauty.
Financial models are idealised representations of the real world.
Neither is real. Models don’t quite work in the way that the real world
works. There is celebrity in both worlds. In the end, there is the same
inevitable disappointment.
Do you see credit default swaps unravelling? What are the kinds of problems you foresee there?
CDS
contracts are economically similar to credit insurance. The buyer of
protection (typically a bank) transfers the risk of default of a
borrower (the reference entity) to a protection seller who for a fee
indemnifies the protection buyer against credit losses.
CDS
contracts and the structured credit market were originally predicated
on hedging or transferring credit risk. Over time the market changed
focus —- in Mae West’s words: “I used to be Snow White, but I drifted.”
The ability to short credit, leverage positions and trade credit
unrestricted by the size of the underlying debt market have become the
dominant drivers of growth in the market for these instruments.
Documentation
and counterparty risk means that the market may not function as
participants and regulators hope if actual defaults occur. A
significant proportion of protection sellers is financial guarantors
(monoline insurers) and hedge funds. As the credit crisis deepens, the
level of defaults will increase. The CDS market will be tested. While
there have been a few defaults, the market has not had to cope with a
large number of defaults at the same time. CDS contracts may experience
problems and may be found wanting. When default occurs the hedgers
might find them “naked” and “unhedged”.
The intricacies of the
CDS contract and its operation are not well understood by users. Credit
derivative dealers talk about their market in much the same way spotty
teenagers talk about sex. A lot of people profess to be accomplished
experts, but when it really boils down to it, most of them are still
fumbling in the dark. CDS contracts may not actually improve the
overall stability and security of the financial system but create
additional risks.
How did the current sub-prime mess in the US start?
Sub-prime
is just one example of a global problem of excessive lending against
overvalued assets to borrowers who don’t have the means to service that
debt. The problem was caused, in part, by the build-up of savings in
the world looking for high quality debt (AAA or AA) to buy. Banks were
encouraged to lend to people they probably never should have lent to on
overambitious terms.
The dodgy debt was converted into
high-quality debt using structured finance techniques and rated by
rating agencies using models whose assumptions proved to be incorrect.
AAA-rated debt based on portfolio of poor quality loans made a lot of
people a lot of money in the short run but the chickens are coming home
to roost.
Basically, a pig with lipstick is still a pig. The same business
model was used in private equity loans, commercial property and
infrastructure and it is all going to have to be unwound.
Where do you think the sub-prime mess will end?
The
high levels of global leverage have to be reduced. The financial system
is de-leveraging. Credit creation and lending is pretty much at a
standstill. This will, in turn, force companies and consumers to
de-leverage by selling assets or deferring investment and consumption
to reduce borrowing levels.
The process will be a slow one
taking years. The amount of money lost (current estimates are in the
range of $1-2 trillion) will beggar belief. It may also hamper global
growth rates for an extended period. The Goldilocks economy is over —
the bears have well and truly returned home.
Most financial crises over the last 25 years have their
origins in derivatives. Given this, why do people go back to it, not
learn from mistakes?
Derivatives are a tool. It is the
misuse that has become problematic. Using derivatives to manage risk
provided you understand what you are doing is fine. Increasingly
derivatives have been used to create leverage and amplify risks.
The
problem is exacerbated by the lack of knowledge of many participants,
the adverse incentive structures (a “heads I win, tails you lose”
culture) and the fact that all the games are played with other people’s
money. As for repeating the errors, that is a general human trait. As
Giuseppe di Lampedusa (author of The Leopard) observed: “Everything
must change so that everything can stay the same.”
source:dnaindia