Sean Sprackling, partner at Investment Solutions Consultants urges participants not to lose faith in derivatives.
The events of the past few weeks have clearly been unprecedented in the annals of the global financial system, and as an interested party I have been avidly following all that has been said in print and on-line. Now, whilst the usual commentators have been, in the main, pursuing their usual measured approach, there also appears to have been a large tranche of people who have happily leapt aboard the bandwagon – and who have stoked the fires of hysteria to new levels. This article, I hope will try to bring a more objective, emotionless view to what is actually going on and (more importantly) what we should be doing about it.
Undeniably we are in a period of crisis. A stygian gloom has settled across the major financial centres of the world and the harbingers of doom are predicting global meltdown – governments will fall, terror will reign and so on. I have seen many articles that have picked up on Warren Buffet’s mantra that derivatives are financial “weapons of mass destruction” (though ignoring the fact that Berkshire Hathaway does in fact have rather large derivatives positions). People are blaming the tools of the trade – the derivative instruments themselves – and sounding a clarion call to “tame the derivatives beast”. There have been calls to scrap the OTC market itself and bring everything on-exchange; the British government has even banned short-selling, thus implicitly accusing the Hedge Funds of being behind the fall of Lehman’s and HBOS.
Personally I do not find any of this particularly useful or enlightening. We are indeed exploring new territory, and we need to navigate through these troubled waters together. But in order to do this we need to understand ALL the causes of this crisis in order to rectify them.
So if we look back at what has actually happened we will find that it is a large number of reasons for the crisis – some that are related to derivatives, some that are not.
1. Low interest rates – following the technology downturn in the early part of this decade, a global lowering of interest rates created a spike in the credit markets. As Secretary Paulson said “lax lending practices earlier in the decade led to irresponsible lending and borrowing”. The result was a bubble that was always going to burst at some point.
2. Housing Markets – globally these too (in part driven by the credit bubble but also by a increasing global social desire for house ownership) became overvalued in areas as diverse as the US, UK, Spain and China. Again, a correction was necessary and is happening as we speak. The very terms that used to describe this market, “Sub-Prime Lending”, NINJA Mortgages (No Income No Job or Assets) should have been ringing alarm bells.
3. Credit derivatives – whilst we can not blame the instruments themselves, we can accuse participants of their intrinsic understanding of them. To me financial innovation is a wonderful thing, and the credit derivatives that emerged from this credit bubble (Sub-Prime MBS, CDOs, CDO2, synthetics etc) were clever but complex. Oftentimes those that traded them did not really know what they were selling, and those that bought them had not really understood the risks involved in holding them. A case in point is the Hedge Fund Paulson & Co. which was one of the few institutions to fundamentally analyse the products and drill down to the instruments that the derivatives were based on – and strangely they have come out of this period with record profits. Similarly the rating agencies and the regulators too did not seem to fully comprehend the complexity of the contracts, and buyers relied on their incorrect assessment of the risks involved. In a market without regulation we seem to have relied on the rating agencies to act in the regulators stead. This clearly cannot continue.
4. Investment Banking – the old investment banking model has proved to be unsustainable (as today’s announcement by Goldmans and Morgan Stanley has proved). However, in my view there are still several issues that have to be addressed that taking retail deposits will not be a panacea for. The culture of rewarding short-term profits has to change, as does the silo’d nature of many of the broker-dealer banks. Not only do these firms have to be able to see their exposures on an enterprise-wide basis, but they must see Risk Management as a basic tenet of their operating model.
However recognition of the causes of the crisis is only part of the solution. The rest is clearly coming up with solutions to the problems that are future-proofed and universal. As a consultant to the buy-side here are some thoughts on what the industry and individual firms should be doing from a buy-side perspective:
Central Clearing – there is already an appetite for this in the market with several groups and bodies investigating it. A CCP will allow for exposure netting and centralised position management.
Tear-Ups and Reconciliation – individual firms should likewise be signing up for these services (such as those offered by TriOptima and MarkitWire) to ensure regular reductions in unnecessary exposures.
Risk Governance – in time we will be calling ourselves Risk rather than Fund Managers. To achieve this, firms should ensure that they have governance structures and processes in place to measure not only investment, but counterparty and operational risks as well. This means having the correct (and correctly educated) committees, and management information systems capable of reporting on these risks. Part of the problem with AIG was that they were not able to fully calculate their liabilities (never a good thing for an insurance company!) – firms must be able to calculate their firm-wide exposures as a basic rule of operation.
Collateral Management – too many buy-side firms think of this as a necessary evil, whereas in fact it is wonderful credit risk mitigation tool. Firms should be looking at their ISDA agreements, ensuring that they are set at the right level, and ensuring that they have operational staff in place that understand the role of collateral management. It is noticeable that there are only a few systems out there available to the buy-sider in this area, and most people tend to outsource this function. Perhaps it is therefore time to bring it back in-house?
Systems – spending money on technology in a downturn may not be the first thing on the mind of executives, but dealing in and holding derivative contracts requires a robust and scalable operating model and one that cannot just be tacked on existing long-only ones designed for cash securities. Fund Managers must have the systems to manage, assess and measure their risk exposures; Risk personnel must be able to run stress and scenario tests on a regular basis, and firms must be constantly re-assessing the models that they have come up with.
Pricing and Data – standardisation is the key. Though this may sound like an oxymoron in the bespoke OTC world, the industry has already taken great steps toward this with the increasing use of FpML and standard pricing models for the less exotic derivatives, but the industry as a whole needs to keep pursuing this.
These points are not designed to be a magical elixir that will cure all ills. They should merely be a re-stating of what participants already knew, but a re-stating that seems necessary to cut through some of the hysteria that abounds at the moment. Let us not forget why we, as investors, use these products. They are there to hedge out risks and to occasionally provide alpha. The OTC market will not die as many people have been calling for as it provides us with a customised solution to our individual portfolios – something that exchange traded products can never do unless we want a world where all portfolios are the same. We do however need to ensure that all systemic risks are addressed so that a crisis of this nature does not recur.
*Sean Sprackling is a partner at Investment Solutions Consultants, a London-based financial services advisory group specialising in investment management.
