I spent over 10 years in derivatives, from 1993-2003. My role was a transactor in the Structuring and Origination part of the business, advising corporations on all manner of risk management strategies. During this time I saw the power – and the risks – of inappropriate derivatives transactions, either due to unnecessary complexity or blatant mis-application. The 1994 derivatives blow-ups of Proctor & Gamble, Gibson Greetings, Air Products and Orange County, the 1998 leveraged bets of LTCM and assorted scandals ranging from MG to Barings to various municipalities marked the ebbs and flows of the industry. I spent the better part of 1994-95 restructuring broken transactions and giving “best practices” presentations, only to see many of the same mistakes made again and again over the subsequent decade. I have seen the “it” asset class move from interest rates to equity to credit, and transaction volumes move from billions to many trillions. It is a new – and scary – world. My years in derivatives as a practitioner, and now as an observer, have taught me many things and clarified my view of how and where these instruments should be used. Bottom line: an exchange-based model is the way forward for the good of hedgers and speculators, promoting stability of the financial markets and protection of governments and taxpayers across the globe.
The OTC market was cool – for making money
I was a big proponent and beneficiary of the over-the-counter (OTC) derivatives market. Customized and client-specific, these transactions also meant something else: fat spreads. By the time the 1990s rolled around, spreads on vanilla derivative transactions collapsed rapidly and new entrants moved in and competition increased. Doing a vanilla fixed-to-floating swap off the back of a bond issuance or floating-to-fixed swap to lock-in the rate on a bank financing simply wasn’t interesting – from a compensation perspective. Knock-ins, knock-outs, up-and-outs, down-and-ins, embedded bermuda swaptions, momentum caps, etc. all helped to differentiate solutions from competitors and preserve proprietary profits in trades. Volumes off the corporate desk simply weren’t great enough to make a business solely on vanilla trades, and smart and creative derivative originators, structures and traders found ways to “add value” through complexity. The question always was: does the structured solution better meet the client’s needs than the vanilla option? It was our job to convince the client that this was, in fact, the case. And sometimes it was, but other times it wasn’t.
Bought and sold optionality – toxic or transient insurance
Trades ranged from those that substantially increased risk through complexity (such as the P&G swap, with an implied duration of 100+ years, which meant it was massively leveraged and hedging absolutely nothing) to those that decreased risk through complexity (such as vanilla swaps with embedded sold options that produced cost savings under a wide range of outcomes but whose protection would go away under large rate moves). The trades that increased risk had durations that far exceeded those of the hedged underlying, while those that decreased risk had durations that were less than those of the hedged underlying. Those that increased risk could blow up and generate eye-popping losses, while those that decreased risk had ugly mark-to-market values over their lives until the embedded optionality decayed over the swap’s life. The bottom line, of course, is that nothing was free. Cost savings over a range of scenarios could rapidly be consumed by unexpected rate moves, but these were the bets made by corporate treasury departments every day and pushed by Wall Street derivatives professionals. And the compensation imperative was present in the corporations as well, where treasury departments were often treated as profit centers driven by money made on derivatives trades. So all that embedded optionality in swaps that reduced financing costs by 40 bps per annum – unless…? Corporate treasury staffers got paid on that this year, notwithstanding the fact that these trades could blow up in later years. This was a huge flaw in the corporate compensation model, a weakness that ended up generating billions of losses through inappropriate transactions done in the name of individual compensation. Sound familiar?
Educating clients – who only understood half the story
After the high-profile 1994 losses, banks became much more sensitive about client communication when it came to derivatives. At Citi, we had “client appropriateness” letters for each corporation that were signed by both the coverage banker and the derivative professional, which were updated every year. This was the bank’s way of saying to the Fed: “If you come and audit us, we’ve already thought about which clients are suitable for certain kinds of derivative transactions.” Further, we needed to document all client communications and to show sensitivity analyses for all transactions the clearly showed the downside scenarios, in order that the client could never come back and say “But you never told me this could happen.” I always kept copious notes and detailed deal files, which were, in fact, reviewed by bank examiners on several occasions. They loved my files, because they were clear in both numbers and narrative. But at the end of the day, the examiners and certain less sophisticated clients had only a surface-level understanding of the solutions, and didn’t really comprehend each piece of the structured solution but only the results of the bundled product. And in this era most clients weren’t focused on mark-to-market issues as hedge accounting rules (FAS 133 – Accounting for Derivative Instruments and Hedging Activities) hadn’t fully been enacted. As long as the trades were risk-reducing they were treated as hedges, and changes in swap value would be used to offset the change in value of the hedged underlying. Derivative pros made a lot of money in this era.
Rising commodization – and a push to other products and asset classes
By the late 1990s, the interest rate swap business became very uninteresting. FAS 133, which put a huge crimp in the structured swap business together with every bank on the planet opening a derivatives trading desk caused the brains to flee to more fertile pastures – equity and credit-related transactions. While the equity and credit derivative businesses existed in the mid-late 1990s, they really took off around the new millennium. And while many of the solutions had less pure math complexity than the interest rate transactions, they had plenty of accounting, tax, legal and regulatory details that created barriers to competition and offered opportunities for proprietary profits. Much larger, in fact, than those available during the halcyon days of the interest rate derivatives market of the 1990s. And while the equity derivatives market was huge – buyback-related transactions, private mandatory convertible instruments for monetizing large stakes in other companies, structured capital-raising transactions – it eventually was dwarfed by the credit derivatives market and its offshoots. As complex as the market was in the 1990s, it became orders of magnitude more complex – and large – in the 21st century.
Where do we go from here – lessons learned
The evolution of the derivatives markets over the past 20 years have made clear the power and danger of these instruments. They can mitigate and distribute risk, they can assist with corporate budgeting and planning and they can promote liquidity and efficiency of the cash markets. But the sheer size of the OTC markets and the interconnected web of transactions among global institutions has rendered the current model dangerous and almost impossible to monitor. And the financial markets crisis has laid bare these risks and de-bunked the traditional view that dispersion of risk is at any time and always a positive thing. In a vacuum, this statement is correct. But without an ability to trust counterparties and to understand where the exposures lie, fear can, and has, caused the markets to seize up. This couldn’t happen in a world where the lion’s share of the OTC derivatives market was pushed to exchanges, where simplicity, transparency and liquidity are paramount. Centralized clearinghouses for trading and margin management would have eliminated almost all the factors associated with the current financial crisis. The time for wide-spread commoditization is upon us. Based on experience, the give-up of customization is a small price to pay for price efficiency, liquidity and stability. Like most things, it’s the 80/20 (or, in this case the 95/5) rule: getting the big things right provides the lion’s share of the benefit. In an earlier time, when volumes were small and users were few, the OTC market was an essential element of the development and growth of the derivatives markets. But derivatives have become like air: they’re everywhere. And in their current state, there is only one answer for how the derivatives market can safely promote its use and continued growth: exchanges.