What's the score?

Original headline: The story so far Source: Risk magazine | 01 Jul 2007 Categories: Awards Topics: Awards and rankings

The derivatives market has come a long way since the first issue of Risk magazine was published in December 1987. Nick Sawyer looks back at the early days of the swaps market and some of the seminal moments that have helped shape the business The stock market crash of October 1987 - known as Black Monday - turned out to be extremely fortunate timing for Risk magazine. Investors were left reeling from the nose-dive in stock markets around the globe, with the Dow Jones Industrial Average plummeting by 22.61% on October 19 - the largest single-day percentage decline since 1914. At that time, Risk was in the final stages of preparation for its launch. By the time the first issue hit trading desks in December 1987, risk management had gone mainstream. That first issue contained an in-depth post-mortem of the crash. Early analysis zeroed in on the role played by portfolio insurance - a technique designed to limit the downside of investors' equity holdings by dynamically buying and selling stocks. Many analysts claimed this contributed to a rush to sell by requiring firms to buy when equities rise and sell as the stock market falls. Risk positioned itself as a link between academia and the real world by combining journalism with specialist, technical articles from quants and academics. The magazine quickly took off, helped by some groundbreaking papers in the early days - most notably Fischer Black's March 1988 article, The holes in Black-Scholes. The derivatives market itself was still relatively young. Swaps had emerged a few years before, when IBM and the World Bank conducted what is believed to be the first currency swap in 1981. That first deal, brokered by Salomon Brothers, was a swap between the World Bank's dollar borrowings and IBM's Deutschmark and Swiss franc debt, and enabled both firms to realize significant savings on their funding costs. Interest rate swaps emerged shortly afterwards. By 1983, a number of banks were arranging swaps transactions for their clients on a matched basis. At this stage, swaps took an agonizingly long time to arrange - if a client wanted to conduct a swap, the bank had to find a counterparty to take the other side, a process that could take months. The bank was essentially an intermediary, taking a hefty fee for its troubles. "Every deal needed to be separately negotiated and documented, but spreads were extraordinarily attractive," remembers Tom Jasper, now chief executive of New York-based Primus Guaranty.

Jasper joined Salomon Brothers to work on its syndicated loans desk in the early 1980s, and was asked to build the bank's swaps business in late 1982. The group initially offered intermediation services for its corporate clients in the swaps market before expanding the scope of the business. "We decided to move the swaps business out of corporate finance and down on to the trading floor around 1984, and we were asked to figure out how to trade these things," says Jasper. "I wasn't a trader, so they brought in a young hotshot trader at Salomon, and within three weeks he asked for a meeting with me and my boss, and said 'there's no way these things can ever be traded, I want out of there. This is never going to be anything but a corporate finance business'. That was pretty scary at the time." Despite the skepticism, other banks were also setting up dedicated swaps businesses, among them JP Morgan, which established a swaps desk in 1984 under Connie Voldstad, and Bankers Trust, which was building a swaps business under the leadership of Allen Wheat. But there were a few teething problems in the early days - not least, a lack of appreciation by upper management that trading swaps was not the same as buying or selling bonds. "I joined the swaps desk at Swiss Bank Corporation (SBC) in 1984, and at that time there was only one desktop computer on the entire dealing room floor," remembers Malcolm Basing, chairman of Primus UK in London and global head of swaps at SBC from 1986 to 1993. "When we applied for another one, we had to go through this huge process - do you really need it, can you afford it?" As business began to grow, banks started to realize they could warehouse risk - in other words, rather than spend months looking for counterparties to take the other side of the trade, the bank could take on the risk and hedge it until it found a suitable counterparty. By 1985, a handful of banks, including Bankers Trust, Citibank, JP Morgan, Salomon Brothers and Security Pacific (a firm acquired by Bank of America in 1992), were managing the risks from their swaps business on a portfolio basis. "First we were doing matched trades, then we realized that if we take on an interest rate swap and put on a Treasury hedge, we can actually protect against interest rate risk. The next logical step was to look at the entire book and just hedge the residual risk," explains Chris Goekjian, chief executive of AltEdge Capital, a London-based fund of funds, who was working on the swaps desk in Tokyo for Bankers Trust between 1984 and 1988. That enabled banks to significantly increase the business they were able to transact, leading to an exponential growth in volumes. "Banks started to become dealers rather than just brokers," explains George Handjinicolaou, president of Etolian Capital, a New York-based proprietary trading and advisory firm, and head of the non-dollar swaps business at Security Pacific between 1987 and 1992. "A broker does not take any risk, but once banks took this quantum leap and became dealers by taking the risk until they could offset the other side of the trade, it provided greater market liquidity and facilitated more transactions. It was a phenomenal change, and bid/offer spreads started collapsing." Hand-in-hand with this development came a surge in product innovation. A quick flick through Risk's first glossary of derivatives products, published in September 1989, reveals an array of weird and wonderful structures - roller-coaster swaps, saw-tooth swaps, captions, floortions and lookback options. The market had come a long way in a relatively short period of time. While many bankers had started off using their trusty HP calculators to calculate net present values on dollar swaps, traders were by now using Lotus 1-2-3 spreadsheets to price and risk-manage these instruments - for the most part, through macros the traders themselves had written. If the modelling

was crude compared with today's standards, there was an easy way to ensure the bank offering the product was not burned - by whacking in hefty margins. "Early on, sizeable margins allowed us some comfort. As the margins came in and the complexity increased, computer power became more and more important," says Bill Winters, co-chief executive of the investment bank at JP Morgan in London. As business grew, banks realised they needed to develop more robust models and began hiring staff with quantitative backgrounds, as well as upping their investment in IT. The extent to which firms were applying sophisticated quantitative methodologies to develop pricing and risk management models got to be a way for dealers to differentiate themselves. "We were writing our early models on spreadsheets and there's nothing wrong with that, but obviously as the business grows that was one of the big challenges - putting together systems that could price a portfolio of thousands of positions," remembers Goekjian. "Having a good model was a competitive advantage." But the explosion in volumes caused other challenges too. Non-standardised documentation still meant deals were taking weeks to complete, with each firm negotiating documentation bilaterally and sometimes on a trade-by-trade basis. "Dealers would take a long while to get a bilateral agreement set up. And normally it would be by branch, not by firm - so dealing with Citibank London would be different from dealing with Citibank New York," recalls TJ Lim, a partner and chief executive of NewSmith Financial Products in London, who was a member of the original team that started the swaps desk at JP Morgan in 1984 before moving to Merrill Lynch in 1988. And, mirroring the recent problems experienced in the credit derivatives market, back offices started to come under pressure. "My biggest fear was that the front offices were developing at such a frenetic pace that the back office would not be able to keep up. The ability of back offices to be able to handle these issues was starting to become strained to the point of breaking," says Handjinicolaou. Indeed, this concern became a reality for some houses. In 1987, JP Morgan was forced to drastically scale down its business for around six months due to concerns about how swaps trades were being booked. At the time, the firm was accounting for swaps on an accrual basis, but the figure reported by the accountants was different from what the traders themselves thought they had made. "The reason for the disconnect was one of the basic errors - the front office wasn't able to bring the back office along as the business was growing tremendously," explains Winters. "The bank brought in staff over the summer to help reconcile the few thousand trades that needed to be reconciled. At the end of the six-month review, they concluded that the original assessment was correct and that the team had made the money it thought it had." By 1988, JP Morgan's swaps book was worth about $350 million. But in that six-month period, the swaps desk was severely restricted in the number of trades it was able to transact. "We knew that the books had a huge amount of profit, but the bank wanted to check, so for around six months we could only do five or 10 deals a week. So there was quite a lot of frustration for us," remembers Lim. The challenges posed by non-standardised documentation caused a handful of dealers, led by Jasper, to set up the International Swaps Dealers Association (later to become the International Swaps and Derivatives Association) in 1985. "Once you started trading these products, you really needed standardised documentation. We realised we needed to do something to resolve this issue, but there was also a nomenclature problem - everyone was using different terms for the same thing, so we

needed to standardise the market speak," says Jasper, who acted as first chairman of Isda along with Artur Walther of Goldman Sachs. The first standardised agreements for interest rate and currency swaps emerged in 1987, followed by an addendum in 1989 to cover caps, floors and collars. However, the big breakthrough - and what some still argue is Isda's greatest achievement - was the publication of the Isda master agreement in January 1993. Until then, the documentation had focused on asset class or product. The master agreement, however, could be used for any product, covering any asset class. "There was a debate about whether the master agreement should cover a broad range of derivatives. But the Isda board decided at a strategic planning meeting in Florida in 1991 that we should create a master agreement that was capable of documenting many different kinds of transactions, not only those we knew about or those like equity derivatives that were out there in nascent form, but those we hadn't even thought of yet. That was a really good decision," says Mark Brickell, chief executive of electronic OTC derivatives market-place Blackbird and Isda chairman between 1988 and 1992. This meant the building blocks were now in place for the derivatives market to step up another gear. More firms were entering the derivatives space - Merrill Lynch, for instance, built up its derivatives business in 1988 led by Edson Mitchell, with Bill Brooksmit as head of US dollar swaps and Connie Voldstad running the non-US dollar business. Meanwhile, Allen Wheat moved from Bankers Trust in February 1990 with a team of 12, including Brady Dougan (now chief executive of Credit Suisse Group), Paul Calello (now head of Credit Suisse's investment bank) and Chris Goekjian, to set up Credit Suisse Financial Products, a quasi-independent, AAA-rated derivatives business. Most of the banks were acting as dealers, although Salomon Brothers had set up a proprietary trading operation in 1984 and integrated the arbitrage business on a global basis in 1987, led by John Meriwether, who later went on to set up Long-Term Capital Management (LTCM). A wider variety of end-users was also using derivatives. On top of corporates and supranationals using swaps as part of their funding operations, insurance companies and banks were starting to use derivatives for asset/liability management purposes, while hedge funds were using them to express macro views and to put on arbitrage trades. "Looking back on the past 20 years, I would say the period from 1982 to 1992 was when derivatives really came of age," says Anshu Jain, now head of global markets at Deutsche Bank, but who was running a hedge fund coverage group at Merrill Lynch in the late 1980s and early 1990s. "Unlike the credit derivatives revolution, which involved established participants that had been using derivatives for a long time adopting a new instrument, this was the fundamental movement from cash to derivatives." But derivatives were also starting to attract the attention of regulators. The industry had already made front-page news in February 1989, when the London borough of Hammersmith & Fulham was ordered by its auditor to stop making payments on its 3.6 billion portfolio of interest rate swaps and options, following legal opinion that the borough should not have put on swaps beyond the notional size of its debt. In January 1991, the UK's House of Lords ruled that all swaps transacted by Hammersmith & Fulham were ultra vires - beyond the authority of the borough - and were declared invalid. The US Commodity Futures Trading Commission (CFTC) had also started nosing around derivatives in the late 1980s - although the regulator, led at that time by chairperson Wendy Gramm, made a policy

statement in 1989 declaring that swaps contracts did not constitute futures, and so did fall under the remit of the CFTC. In 1992, however, regulators were taking a closer look at derivatives. In February of that year, Gerald Corrigan, then president of the Federal Reserve Bank of New York, delivered a speech in which he gave an explicit warning to the derivatives business. The industry realised something needed to be done. On one hand, Isda played a major role in meeting with regulators to explain the benefits of derivatives, as well as lobbying politicians on both sides of the Atlantic. However, it also led to an industry-wide initiative to establish a template for managing the risks associated with derivatives - a document that came to be known as the G-30 report. "That report made it clearer to the outside world that what we were developing in the derivatives world was good risk management technology that could be applied more broadly in the financial system," says Blackbird's Brickell, who served on the working group. "Regulators and legislators saw the truth in this." The group, comprising practitioners, lawyers and accountants, was co-chaired by David Brunner of Paribas and Patrick de Saint-Aignan of Morgan Stanley, and was overseen by a 14-person steering committee chaired by then JP Morgan chief executive Dennis Weatherstone. The report was eventually published in July 1993 and included 130 recommendations - among them the use of value-at-risk and marking positions to market. "The fact that it was under the G-30 gave the report some credibility, and it gave a reasonable summary of what people should be looking at. Maybe they were already doing it, or maybe they were only doing parts of it, but it gave everybody a template they could work towards," says Basing, who was chairman of Isda between 1992 and 1993. The fact that the industry was seen to be tackling these issues arguably saved it from having regulations imposed on it in 1994. Then, several blow-ups put derivatives well and truly in the public glare. The catalyst was the decision by Alan Greenspan, then chairman of the Federal Reserve, to raise interest rates in February 1994 - the start of a prolonged cycle of rate rising that caused a number of leveraged derivatives products to implode. In April, Cincinnati-based consumer products company Procter & Gamble (P&G) revealed a $157 million pre-tax loss on two complex interest rate swaps trades, while Gibson Greetings, a Cincinnati-based greeting card company, disclosed a $19.7 million loss in the first quarter due to a single swap contract. Then, in December, Orange County announced $1.6 billion in losses stemming from then-treasurer Robert Citron's use of interest rate derivatives. Worse, both P&G and Gibson Greetings announced they planned to sue Bankers Trust for mis-selling these products - a case that suddenly looked stronger after a telephone transcript of two Bankers Trust employees revelling in the profit built into a structure sold to P&G was published in Business Week in 1995. The whole sorry affair made banks think very carefully about how they were selling products, and the compliance and control processes they had in place. "In these cases, the greed factor became too evident, and some of the dealers took some of the clients for a ride and were putting so much profit into the transaction that it was obscene," says Handjinicolaou. "We used to say 'if this product comes up on the 10 o' clock news, would we be able to defend it?'. If the answer was 'no', then we did not do it."

Suddenly, you couldn't open up a newspaper without a negative story about derivatives staring back at you. Politicians also started to take notice, with some prodding regulators such as the Securities and Exchange Commission to take action. Isda, in response, stepped up its lobbying efforts. "We spent thousands of hours in Washington, London and Tokyo. We visited any regulator that wanted to understand derivatives better, we were talking to congressmen and senators - we wanted everybody to understand what we were doing," says Brickell. "One of the hallmarks of our effort was that it was knowledge-based - anybody who was interested and was in a position to have an effect on policy, we were there to explain how the industry worked." This effort continued pretty much non-stop until the US Congress gave final approval to the Commodities Futures Modernization Act of 2000, which stipulated once and for all that the derivatives were not subject to regulation by the CFTC, effectively preserving their status as OTC instruments. This effort is widely applauded by derivatives practitioners. "Everyone talks about the Isda documentation but, just as importantly, Isda achieved a regulatory framework that was critical to the growth of the derivatives business," says Frederic Janbon, global head of fixed-income at BNP Paribas. Nonetheless, there were some implications. Product innovation more or less ground to a halt in the US a hangover of the P&G/Gibson Greeting scandal that exists even to this day, say some. "Europe is now far ahead of the US in terms of derivatives usage, and I believe Procter & Gamble, Gibson Greetings and Orange County go right to the heart of it," says one senior banker in London. "The US is the most cashdriven market in the world, and mutual funds still use derivatives with tremendous scepticism. As a result, a whole generation of innovation has passed them by." P&G and Gibson Greetings were mis-selling issues; the collapse of Connecticut-based hedge fund LTCM, however, was very much to do with derivatives, leverage and liquidity. "That's your real derivatives crisis," the London-based banker says. "That was a near miss - we nearly blew the world up." The reasons for the losses are well documented - and are covered in Navroz Patel's article on pages 8891. However, one of the great achievements in the aftermath of LTCM was the 14-bank consortium that put together a $3.625 billion bailout package. "That would be like Coke and Pepsi getting together to save the beverage industry," says Deutsche Bank's Jain. "Had this been a small problem, there is no way the industry would have come together. Everyone understood that it was a case of mutual survival." The past 10 years have seen a continuation of the innovation and development experienced between 1981 and 1994 - as well as witnessing their fair share of disasters. The past decade has very much been dominated by the emergence and explosive growth of the credit derivatives market (see pages 80-83). Once again, Isda has played an important role in developing documentation, helping to iron out teething problems (for instance, the backlog in outstanding confirmations in 2005) and setting standards (the novation protocol in 2005, as well as the launch of auctions to enable cash settlement of credit derivatives trades). Progress Basel II, first published in consultative form in 1999, has sparked huge progress in the development of internal rating models for measuring credit risk, while the second consultation paper, published in January 2001, raised awareness of operational risk by including an explicit regulatory capital charge for this exposure for the first time. After eight years of preparation, banks in Europe and some parts of Asia will implement both the advanced internal ratings-based approaches to credit and the advanced measurement approach for operational risk from January next year.

More and more investors have become involved in the derivatives market, notably retail investors, highnet-worth individuals and mutual funds. Insurance companies are now showing an interest in some of the risk management techniques pioneered by banks during the Basel II process as they prepare for Solvency II, while pension funds have turned to derivatives to shore up huge funding deficits. Hedge funds, meanwhile, have become more sophisticated - rather than just expressing macro views and seeking out first-order mis-pricing, managers are looking to trade a wider array of assets - for instance, volatility, correlation, gamma and skew. This, in turn, has allowed banks to offload and recycle these risks from their balance sheets. All this has contributed to unprecedented liquidity in the financial system. There's always the danger this liquidity could dry up at a moment's notice, as demonstrated by Connecticut-based hedge fund Amaranth Advisors, which collapsed in September last year after it took huge, concentrated positions in the natural gas market. Market practitioners need to be on their guard against any short, sharp shocks and be aware that any new crisis is unlikely to mirror exactly the events of LTCM in 1998, the Asian crisis in 1997 and the 1987 stock market crash. Imagination is needed in stress tests. Nonetheless, the system is arguably stronger than it has ever been - just look at how the market responded to the collapse of Enron and WorldCom, September 11, the correlation crisis of May 2005 and, most recently, the blowing out of delinquencies in US subprime mortgages. "If you think about it, 10 or 15 years ago, corporate chief executives would write in their letters to shareholders how they had suffered because of adverse movements in the dollar/yen exchange rate. People get fired for that now," comments Jerry del Missier, co-president of Barclays Capital in London. "You have the means to make that not an issue. And that's down to advances in risk management, greater liquidity in hedging markets and developments in new markets. This truly is the golden age of risk management." THE RISE OF CSFP By the end of the 1980s, Bankers Trust had firmly established itself as an innovative force in the derivatives markets. Led by Allen Wheat, the bank was at the forefront of new product development (it is widely credited with developing the first quanto swap) and had made a successful push into equity derivatives, importing much of the technology and engineering it had developed in the fixed income and currency markets into this new asset class. By 1990, the derivatives group was generating around a quarter of Bankers Trust's global net profits. But Wheat was becoming increasingly disillusioned with political infighting within the firm. With a team of 12 (including Chris Goekjian, Brady Dougan, Paul Calello, John Zafiriou, JC Cheysson and Trevor Price), he decided to jump ship to set up a new entity, Credit Suisse Financial Products (CSFP), in February 1990. CSFP was to be an independently managed derivatives boutique, with Credit Suisse's AAA rating behind it. The idea was that the group would trade across asset classes, focusing on the more structured end of the spectrum. The AAA rating was essential - it meant the firm could do business with governments, agencies and supranationals. For some of the original 12, the attraction of starting a new venture from scratch was too tempting an opportunity to miss. But the influence of Wheat, who commanded a loyal following from his staff, also played a major role.

"The people followed Allen, who was the architect of the derivatives business as we know it today. We all worked very closely together in developing the whole business and were loyal to Allen," says John Zafiriou, Zurich-based managing director in the private banking division at Credit Suisse, who was head of southern Europe coverage at CSFP from 1990-96. "At CSFP, we had a business where we didn't have to deal with any of the politics and Allen gave us the encouragement and the freedom to launch and develop new ideas. We could get into new things, and that was very important." The initial team had to build a derivatives business from scratch, and so spent much of the first year developing front- and back-office systems and writing pricing and risk management models. The firm started trading towards the end of the year, and quickly became one of the pre-eminent derivatives shops - a fact that is reflected in Risk's rankings throughout the 1990s. "The mandate at the end of the day was to do derivatives and be profitable. The CSFP culture was to be cutting edge, to do new things. If something became commonplace, you moved on to the next thing," says Zafiriou. Towards the end of the 1990s, CSFP started working more closely with Credit Suisse First Boston (CSFB), eventually integrating completely with the investment bank in 1999. Many of the CSFP crowd went on to take bigger roles - although some considered it the end of an era. "People didn't like it," says Chris Goekjian, chief executive of AltEdge Capital, a London-based fund-offunds, and global head of trading at CSFP from 1990. "People felt very special at CSFP because they thought they were working in a top institution. They were doing derivatives, which was an interesting area to be in; it was a growing area, it was obviously a more challenging area, and they didn't really want to be merged into the fixed-income division or the equities division." Goekjian went on to become cohead of fixed income at CSFB, before leaving the bank in 2000 and setting up AltEdge in 2001. "People from CSFP went from a cutting-edge and entrepreneurial atmosphere and with no requirements to do franchise business, to something that was much more, in their opinion, restrictive given the size of CSFB's client base, business model and bulge bracket status," adds Zafiriou. "In the past, I remember telling clients that we were not interested in doing $2 billion swaps, why don't you go to Chase Manhattan. That's something we couldn't continue to do. I think CSFP was the right entity at the right time, but the merger was a natural development - you couldn't deal with clients if you were saying 'I'm only interested in the very structured side'. You needed to have a constant dialogue with the client for all of his needs, whether structured or flow."