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WMD or "What are Derivatives?"

There is a perennial debate about financial WMD (weapons of mass destruction) – derivatives.

The most interesting debate was between two giants of American capitalism – Warren Buffet and Alan Greenspan.

In 2003, Buffet took aim at derivatives calling them “financial weapons of mass destruction” (“What Worries Warren” (3 March 2003) Fortune). He was joined in this crusade by a few notable figures. Their complaint seemed to be that derivative contracts had hidden losses that would eventually emerge. This would affect the banks and insurance companies who traded in these instruments. They were concerned that derivatives allowed companies and investors to gamble with other people’s money. I have always naively assumed that gambling with other people’s money was part and parcel of capitalism. The catchy line with its characteristic homely wisdom and the fact that it was Buffet ensured immediate airplay.

The major defender was Alan Greenspan, Chairman of the Federal Reserve Bank of New York, effectively America’s central bank. Its responsibilities include ensuring the integrity of the financial system and stability of banks. The head of the central bank’s role as cheerleader for the derivatives lobby was curious.

Greenspan had succeeded Paul Volcker in the late 1980’s. Volcker had embarked on an unpopular strategy of high interest rates that had ultimately proved successful in beating inflation. There had been collateral damage. The entire US Savings & Loan Industry had ended up as road kill. But the high interest rates opened up la Belle Époque - an era of low inflation, low interest rates and rising stock prices. Chairman Greenspan found himself in command of the ship just as it sailed into calmer waters. Woody Allen observed that 80% of success in life is just showing up at the right time. The Maestro, Greenspan’s nickname, had immaculate timing.

The tennis playing, jazz saxophone loving Greenspan has presided over an unparalleled period of prosperity, the bond market collapse of 1994 and several asset price bubbles and collapses. Greenspan is famous for two other things - prolix sentence construction and an unfettered belief in new technology.

Greenspan’s regular congressional testimony attracted financial analysts, journalists and linguists in equal numbers. An industry in interpreting Greenspan’s prognostications has developed. Without a hint of self-parody, Greenspan himself provided guidance to interpreting his pronouncements. “I know you believe you understand what you think I said, but I am not sure you realize that what you heard is not what I meant,” the Maestro once offered as explanation. He further clarified his position with unusual directness. “If I have made myself clear then you have misunderstood me.” (David James “Wot’s all this then, Alan?” (10-16 July 2003) BRW)

Now, Greenspan turned his considerable elocutionary powers to the defense of derivatives. During the height of the Internet boom, he held forth lyrically and at length on the impact of technology on productivity. Greenspan’s infatuation with derivatives appeared no less intense.

“By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives….. As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly. Should they succeed I am quite confident that market participants will continue to increase their reliance on derivatives to unbundle risks and thereby enhance the process of wealth creation.” Remarks at the Futures Industry Association, Boca Raton, Florida (19 March 1999).Thus spake Greenspan.

But who is right? What are the WMD – “derivatives” - they were referring to?

During the Iraqi conflict, Donald Rumsfeld, the US Defense Secretary, inadvertently stated a framework for understanding the modern world (12 February 2002 Department of Defense News Briefing). The framework perfectly fits the derivatives business. There were “known knowns” – these were things that you knew you knew. There were “known unknowns” – these were things that you knew you did not know. Then, there were “unknown knowns” – things that you did not know you knew. Finally, there were “unknown unknowns” – things that you did not know you did not know.

In most businesses, the nature of the product is a known known. We do not spend a lot of time debating the use of or our need for a pair of shoes. We also understand our choices – lace up or slip-on, black or brown. I speak, of course, of men’s shoes here. Women’s shoes, well, they are closer to derivatives. Derivatives are more complex. You may not know that you need the product until you saw it – an unknown known. You probably haven’t got the faintest idea of what a double knockout currency option with rebate is or does – a known unknown. What should you pay for this particular item? Definitely, unknown unknown. Derivatives are similar to a Manolo Blahnik or Jimmy Choo pair of women’s shoes.

And do derivatives relate to other known financial “things”? Bonds, stocks etc. The “physical” markets. Commissioner Sharon Brown-Hruska of the Commodity Futures Trading Commission framed the definitive formulation: “The physical markets are like the body of the dog in that they contain the fundamental information about the market. The tail is composed of trading markets like futures markets. It is connected to the dog but one of its primary functions is to tell us about the dog: is he happy or mad? Does he need to be fed? Or should we put a collar on him?” (see FOW (May 2006) at 62). Derivatives, it seems, are a strange combination of knowns and unknowns and canine appendages.

Derivative professionals deal daily with combinations of knowns and unknowns. This was even before the Defense Secretary articulated the principles. They had not known that they had known all along – an unknown known. The unknowns, both known and unknown, create fear and suspicion. The knowns are synonymous with greed.

Derivatives are a known known - known to be WMDs (weapons of mass destruction). After all, the august figure of Warren Buffet said so. There was no doubt that they existed. The results of the use of WMD littered financial history – Barings, Proctor & Gamble, Gibson Greeting Cards, Orange County, Long Term Capital Management (LTCM). A known unknown is why people dabble with WMD. What could they hope to gain? It is definitely a known unknown.

The unknown known is also self evident. Derivatives are a simple case of greed and fear. Clients use these instruments to make money (greed) or protect them from the risk of loss (fear). Frequently, they confuse the two. Clients are fearful that they will miss out on the promised bonanza – fear of losing out on greed. Dealers also use these instruments to make money, primarily for themselves (greed). They frequently deal in WMD because they fear that if they did not then their competitors will (fear). They too it seems fear losing out on the proceeds of greed. The dealers also fear that in trading derivatives their greed will lead to losses (more fear). No one in the derivatives industry really wants to admit this. Most of all they do not want to admit this to regulators and politicians. They just might do something about it (the sum of all other fears).

The unknown unknowns are more difficult. There are probably many of these. But no one knows them, of course, at least not yet.

The above is an edited extract from Traders Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das (2006, FT - Prentice Hall, London, ISBN 0273 70474 5) available at all good book stores or online at www.pearson-ed.com.

Satyajit Das is a specialist in the area of financial derivatives and risk management. He is the author of a number of key reference works on derivatives and risk management. His works include Swaps/ Financial Derivatives Library – Third Edition (2005, John Wiley & Sons) (an 4 volume 4,200 reference work for practitioners on derivatives). He is also the author of Credit Derivatives, CDOs and Structured Credit Products –Third Edition (2005, John Wiley & Sons) and Structured Products & Hybrid Securities – Second Edition (2001, John Wiley & Sons). He is the author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (forthcoming, April 2006, Pearson Education), an insider's account of derivatives trading and the financial products business filled with black humour and satire. He is also the author (with Jade Novakovic) of In Search of the Pangolin: The Accidental Eco-Tourist (forthcoming, June 2006, New Holland), an unique travel narrative offering passionate and often poignant insights into the natural world and the culture of eco-travel.