The man who saw the (new) futures?
(From Fortune:)
Leo Melamed, godfather of the Chicago mercantile exchange, changed investing forever with financial derivatives. Here’s what this market visionary thinks is next.
Way back in 1972, the head of the Chicago Mercantile Exchange had a crazy idea: If you could trade futures on pork bellies, wheat and beef, Leo Melamed wondered, why not on Swiss francs or deutsche marks? Or any other financial instrument for that matter? That notion has radically changed the way market risk is managed.
Way back in 2000, Andrew Black and Ed Wray had a crazy idea: If you could trade derivatives on financial instruments, why not on the outcomes of horse racing or soccer? or any other sport for that matter?
Here in 2007 (and for the past 2-3 years), I’ve been thinking about what I call particle finance, as analagous to particle physics. I firmly believe that advances in information and communication technology will allow us to reduce financial (and more broadly speaking) risk management to its smallest and most fundamental component parts. We are on the verge of discovering and being able to manipulate the quarks of the risk management universe. The ramifications (if my thesis is correct) are enormous and potentially highly disruptive.
In many instances progress will be hampered by powerful incumbents protecting the status quo via regulatory and legislative barriers. But ultimately I don’t think you can keep the genie in the bottle; the US in particular runs the risk of losing it’s pre-eminent position as an innovator in financial services and risk management unless they succeed in reforming their often parochial and restrictive regulatory environment. This in fact was the conclusion of Mayor Bloomberg and Senator Schumer in their recent report on the future prospects of New York as a global financial center:
The joint report stipulated that while many of the causes are due to improved markets abroad and sophisticated technology that has virtually eliminated barriers to the flow of capital, a significant number of the causes for America’s declining competitiveness are self-imposed. For instance, U.S.-based financial services firms are now unable to attract and retain many of the highly-skilled professionals they need because of caps on the number of visas available under U.S. immigration rules. A greater perceived litigation risk has also reduced the appeal of the U.S. market to many foreign firms. Finally, a complex and sometimes unresponsive regulatory framework has not only prompted many foreign firms to stay out of the U.S. markets, but also is forcing more business overseas because of the complexity and cost of doing business in U.S. financial markets regardless of where they are located. The joint report offered several recommendations, derived from detailed analyses of market conditions here and abroad, informed by interviews with more than 50 respected leaders drawn from the financial services industry, consumer groups, and other stakeholders. The recommendations focus on near-term administrative actions that can signal renewed U.S. focus on competitiveness, actions to level the playing field for both domestic and foreign companies doing business in the United States, and longer-term initiatives to address more complex policy, legal, regulatory and other structural issues affecting the U.S. position as the world’s leading financial center.
Their recommendations are straightforward and would indeed have a powerful liberating effect on American financial and risk markets, to the benefit not only of American individuals and corporations but also globally given both the size and depth of US markets and the proven American ability to marshall innovation (when allowed to do so - it is not a coincidence that the US is starting to fall behind in telecoms and financial services as these happen to be two of the most protected and regulated industries…), let’s hope they gain the grass-roots political traction they deserve and don’t get hacked into irrelevance by the dinosaur brigade:
Recommendations to sustain the nation’s and New York’s global financial services leadership:
Provide clearer guidance for implementing the Sarbanes-Oxley Act;
Implement securities litigation reform with particular short-term emphasis on leveraging the SEC’s existing authority;
Develop a common vision and a supporting set of shared regulatory principles;
Ease immigration restrictions facing skilled non-US professional workers;
Recognize IFRS without reconciliation for listing purposes and promote convergence of accounting and auditing standards;
Protect US global competitiveness in implementing the Basel II Capital Accord;
Form an independent, bipartisan National Commission on Financial Market Competitiveness to resolve long-term structural issues;
Modernize financial services charters and holding company structures;
Establish a public/private partnership to promote New York’s local agenda by acting as the high-level liaison between individual industry participants and the city, as well as by driving forward the partnership’s broader strategic plan for New York’s financial services development.
More actively managing attraction and retention for financial services;
Establishing a world-class Center for Applied Global Finance, and
Potentially creating a special international financial services zone.
Anyhow, to come back to the original point - Leo Melamed and the CME should indeed be celebrated for their role in bringing financial derivatives to life and developing and extremely important and robust set of markets that are now part of the very fabric of our global economy. At the risk of sounding presumptuous, I would love to be able to look back in 20 years on a legacy analogous to Mr. Melamed’s; as one of the people who were instrumental in bringing the benefits of particle finance - of ubiquitous and super-efficient risk management and risk transfer - to a global audience. I’ve often been thought crazy (by my managers or colleagues) but apparently I’m in good company here:
(Leo Melamed describing how he came upon the idea of financial futures) And then, finally, I came to the thought that Bretton Woods, the fixed-exchange-rate system, was coming apart. And when it finally comes apart, wouldn’t there be a need for foreign-exchange futures? Our board thought I was crazy, and very frankly I thought it was a little crazy too, because why hadn’t anybody else done this? I went to Milton Friedman, though, and he absolutely embraced the idea.
Well I don’t have Mr. Friedman but I was a syndicate manager and so I guess my challenge over the coming years will be to successfully syndicate my ideas. I’m still thinking about what the right structure might be…but good ideas, like good bonds, tend to sell themselves (but a good story always helps to get the ball rolling!)
February 21st, 2007 at 4:00 pm
Did you read today’s article about “Death Bonds” in the WSJ? What’s your take on the increasing move inside insurance companies to securitize “excess” reserves? Is it just a conversion of equity to debt so as to raise ROE, or is this the next step in the creation of the risk quark?
-JD
February 21st, 2007 at 8:56 pm
The companies that will show real success here are the ones that can break up and re-bundle some of the risks facing households and small businesses. The famous “great risk shift” has left more people with more risk than they’re comfortable with, at the same time that investors are looking for new securities to trade. Imagine a mortgage company that protects customers from a real estate bubble pop by bundling housing index futures into the loan package, or a car dealership that sells gasoline futures to cover the life of the car through the finance department. (GM already did this, but only for one brand of car. Why not let Dobbs Chevrolet/Cadillac/VW sell the futures as an option to the VW buyers?) An entrepreneur could hedge a store’s exposure to a doubtful location with futures on a crime statistics index, or a trade school could help you trade on the BLS stats for your occupation to hedge the risks of possible future job search and retraining. The trick is somehow to make it easy for a user to invest in “risk quarks” as part of the transaction that exposes the user to the risk, and not require the user to learn yet another trading system if he or she doesn’t want to.
February 25th, 2007 at 9:52 pm
great comment don. bingo. I agree entirely - the great risk shift is a great tagline that captures the paradigm exactly. This is what will drive a massive structural shift in how financial - or (more generally) risk - markets will evolve over the coming decade or two. Instead of having numerous and large intermediaries (banks, securities firms, insurance companies) sitting in the middle aggregating, warehousing, managing and repackaging risks (and capturing huge margins/rents for their efforts), you will have risk exchanges and algorithmic ‘bots’ dynamically matching, trading and managing the risk quarks for everyone. The legacy analogy is the ’securitization’ of institutional or corporate risks (bonds instead of bank loans for example)…
February 25th, 2007 at 10:21 pm
Didn’t see the ‘death bonds’ article jd…behind a paywall. However I think I know what it might have covered and wrt your question I would say the answer is both. The reason insurance companies are (being pitched by investment banks) and doing these deals is to raise the efficiency of their balance sheets and drive EVA (or other return on capital metrics.) However - and inadvertly (ie I don’t think any of the actors involved are really aware or interested in this aspect…) - it is another step down the road to splitting the financial atom. Actually to stick to the metaphor, this is probably up the chain a bit and more of a chemical rather than atomic process and so still a few steps away from risk quarks, but the direction is clear.
February 26th, 2007 at 5:31 pm
Sean,
I think you are right about the securitization of insurance reserves being up the ladder a long ways from the “risk quark.” What I puzzle on conceptually is if it is a move in the right direction. It is risk de-aggregation to break insurance reserves into smaller risklets and sell them off with a layer of reinsurance. But it still seems so loaded with transaction costs and possibly be a branch of risk de-aggregation that may not lead down the quark path.
On a slight tangent: Somehow in all of this discussion of splitting the risk atom, there has to be discussion of human risk perception and, more importantly, cognitive bias as it relates to risk. In addition, there has to be an exponential reduction in transaction costs. Huge progress in these two areas seems like a necessary, but not sufficient precursor to greater risk deaggregation.
-JD
March 5th, 2007 at 12:34 pm
It is very possible that insurance securitization as we now know it could in fact turn out to be an evolutionary dead end in terms of the path of discovery with respect to splitting the risk atom. Ie there may be a ‘better way’ to drive towards the same end (rendering tradeable and manipulable - is that a word??? - the elementary particles of risk), although at the risk of pushing the metaphor too far, perhaps some equivalent of the uncertainty principle will operate once you get to fundamental risk particles…
Wrt transaction costs - I completely agree, and indeed think that this is the primary driving force behind a new paradigm in financial services and risk management. Indeed while many of the concepts that will drive this change are not necessarily novel or fabulously innovative, they were previously irrelevant as their implementation depends entirely upon a frictionless (or very very close to it) marketplace. It is only in the past few years that we are starting to see anything like this becoming a possibility. On the other hand, the reduction in transaction costs seems to be governed by some sort of power law, so even if we’re not there yet, it could all happen more quickly that we would expect.
Insofar as how the ‘human element’ will play out in this transformation, I would also agree that it is a key input, and harder - at least for me - but I’d speculate not impossible to understand. I’d highly recommend Behavioral Finance by James Montier, an ex-colleague of mine, as a good starting point in terms of understanding how humans process risk.
March 22nd, 2007 at 3:37 pm
Sean, thanks for the Montier recommendation. I put his book in my Amazon queue. It will be in my next order.
May 8th, 2007 at 6:43 pm
[…] As someone who used to run a credit trading business at a large investment bank, I obviously have a view on the micro and macro issues surrounding credit derivatives, and perhaps the fact that I am no longer in such a position (and so no longer have a direct vested interest) will actually will give sceptics pause before dismissing my unreserved belief that they are - like any financial derivatives allowing better and more granular risk management (see my earlier thoughts on particle finance and risk quarks) - a welcome and useful addition to the financial ecosystem. And given the importance of credit risk in the risk firmament (in terms of explicit and implicit exposures embedded in the economy) it is no surprise that the market is growing exponentially in size and sophistication. […]
May 28th, 2007 at 5:52 pm
[…] had been first developed by Charles Sanford (Chairman of Bankers Trust from 1987-1996) and that it hadn’t worked out too well for Bankers. Entertaining and clever writing perhaps, but the greed and ethical vacuum that eventually brought down Bankers was not the inevitable result of smart, forward thinking on risk (but rather imo the result of insufficient and poor middle management overwhelmed by a gold rush mentality.) Indeed the number of Bankers Trust alumni that have driven innovation and risen to senior positions across the financial firmament is a more apt illustration of the importance of these ideas. I was also curious to learn that Mr. Sanford had first developed the concept of particle finance, I had not encountered this metaphor before first using it myself a few years ago (and I have to admit it made me smile to see a Park Paradigm post at the top of the “particle finance” Google search, just ahead of Mr. Sanford’s 1993 article ‘Financial Markets in 2020′, reprinted in the Federal Reserve Bank of Kansas City Economic Review!) but it is nice to see that this way of looking at the (inevitable) evolution of risk management has other significant champions. The vision he articulated in 1994 (when I was just a young whippersnapper of a bond trader, flinging around the front end of the French yield curve) is remarkably clear and insightful, and all the more so for having been written before the financial/technological boom of the late 1990s. I only wish I had first read it in 1993! And if any readers out there know Mr. Sanford, please let him know that I’d love to buy him a coffee and find out what he thinks now that we are halfway to 2020…and talk of risk quarks, Of shoes—and ships—and sealing-wax— Of cabbages—and kings— And why the sea is boiling hot— And whether pigs have wings.” Trackback · […]