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Sovereign CDS – The Case for Control

In an opinion piece entitled “Hedging bans risk pushing up debt costs” published on 9 March 2011 in the Financial Times, Conrad Voldstad, the chief executive of the International Swaps and Derivatives Association (“ISDA”) and formerly a senior derivatives banker with JP Morgan and Merrill Lynch, made the case against the EU ban on “naked” credit default swap (“CDS”) contracts on sovereigns.

Just as “patriotism is the last refuge of a scoundrel”, arguments citing market efficiency and the benefits of speculation seem to be the first resort of dealers. The familiar case was that prohibition was unnecessary, would decrease liquidity, increase borrowing costs and create greater uncertainty for European firms. The arguments are self-serving and do not present a balanced view of the issues.

The EU rule does not impede genuine hedging. If an investor owns sovereign securities or a firm has receivables that rely on the sovereign directly or indirectly, then purchasing protection using a CDS is permitted.

ISDA argues that banning naked CDS would have a detrimental effect on individual country’s borrowing costs. The article cites an EU study that found that the sovereign CDS market was small relative to the size of underlying bond markets and had negligible effect on credit spreads. Given this evidence, it is puzzling why banning these contracts would somehow affect pricing.

The real issue is that a ban on naked CDS on sovereigns is seen as the “thin end of the wedge”, ushering in greater control on the size of the derivative market, limits on the purposes for which derivatives are used and also on the types of derivative contract permitted. Given the substantial derivative trading profits earned by major dealers, ISDA’s position is predictable.

Historically, CDS contracts were used for hedging. Buyers of protection used these contracts to hedge the risk of default of a firm or country. CDS contracts avoided the need to transfer loans or sell illiquid bonds. It also allowed greater flexibility in hedging and offered ease of documentation. Investors could sell protection to acquire credit exposure, especially advantageous where there was no liquid market in the borrower’s bonds.

Over time, speculative factors came to drive the CDS market. The ability to short sell credit became more important. Buyers of protection, where they did not have any underlying exposure to the issuer, sought to profit from actual default or deterioration in its financial position.

Sellers of protection used CDS contracts for leverage. Selling protection on an issuer required minimal commitment of cash (other than any collateral required by the counterparty). In contrast, purchase of a bond required commitment of the full purchase price.

As trading was not constrained by the physical availability of bonds or loans, the CDS markets were more liquid than comparable bonds, facilitating trading.

The shift from hedging to speculation improved liquidity but at the cost of increased risk. The global financial crisis exposed the complex chains of risk and the inadequate capital resources of many sellers of protection.

ISDA’s argument that a ban on naked sovereign CDS will adversely affect Europe’s financial stability is disingenuous. Speculative trading in sovereign CDS is likely to be more destabilising, allowing potential market manipulation.

In practice, sovereign CDS volumes are low and large traders can influence prices, which frequently affect the values of bonds as well as CDS contracts. Commenting on the problems of AIG’s CDS positions, George Soros accurately stated the true use of these contracts: “People buy [CDS] not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. AIG thought it was selling insurance on bonds and, as such, they consider CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.” [George Soros “One Way to Stop Bear Raids” (23 March 2009) Wall Street Journal].

The response of the industry to the EU proposal reveals that participants are unwilling to admit the unpalatable realities of derivative trading. Much of what passes for financial innovation is a vehicle for unproductive speculative activity, specifically designed to conceal risk or leverage, obfuscate investors and reduce transparency. The aim is to generate profits for dealers.

However, those who believe that the ban on naked sovereign CDS is a sign that regulators and legislators want meaningful reform of derivative trading are equally deluded. Control of sovereign CDS trading is one of a series of half-baked EU measures, seeking to deal with the intractable problems of a number of heavily indebted sovereigns. Unfortunately, banning sovereign CDS contracts will not solve the problems of excessive indebtedness. It is nothing more than a diversionary tactic that also obfuscates the real issues.

Activity on all sides of the sovereign CDS debate increasingly is a substitute for achievement.

© 2011 Satyajit Das All Rights reserved. Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Grecian Derivative

In his “Ode on a Grecian Urn”, the English Romantic poet John Keats declared that “beauty is truth, truth beauty”. In derivatives, its seems transactions may be “beautiful” but are frequently not “truthful”.

Advocates of derivatives argue that derivatives are primarily used to hedge and manage risk. In order to do this, derivatives, such as interest rate and currency swaps, are used to alter the nature and currency of the cash flows on existing assets or liabilities. Transactions entail exchanges of one stream of payments for another. At the commencement of the transaction, if the contract is priced at current market rates, then the current (present) vale of the two sets of cash flows should be equal (ignoring any profit). The contract has “zero” value – in effect, no payment is required between the parties.

Using artificial “off-market” interest or currency rates, it is possible to create differences in value between payments and receipts. If the value of future payments is higher than future receipts, then one party receives an up-front payment reflecting the now positive value of the contract. In effect, the participant receives a payment today that is repaid by the higher than market payments in the future – identical to the characteristics of a loan. Any number of strategies involving combinations of different derivatives can achieve this effect.

In the 1990s, Japanese companies and investors pioneered the use of derivatives to hide losses – a practice called “tobashi” (from the Japanese, tobasu, the verb, means “to make fly away”). Since then, the use of derivatives to disguise debt and arbitrage regulations and accounting rules has increased.

In 2001, academic Gustavo Piga identified the case of an unnamed European country, that everyone assumed was Italy, using derivatives to provide window dressing to meet its obligations under the European Union (EU) Maastricht treaty. There were accusations and counter accusations. The report vanished from the International Securities Market Association (ISMA) web site.

It appeared that in December 1996, Italy used a currency swap against an existing Yen 200 billion bond ($1.6 billion) to lock in profits from the depreciation of the Yen. The swap was done at off-market rates with Italy setting the exchange rate for the swap at the May 1995 level rather than the rate at the time of entering the contract.

Under the swap, Italy paid a rate of dollar LIBOR minus 16.77% reflecting the large foreign exchange gain built into the contract for the counterparty. Given that LIBOR rates were around 5.00%, the interest rate paid by Italy was negative. In effect, the swap was really a loan where Italy had accepted an off-market unfavourable exchange rate and received cash in return.

The payments were used to reduce Italy’s deficit helping it meet the budget deficit targets of less than 3% of GDP (gross domestic product). Between 1996 and 1997, Italy had cut its budget deficit from 6.7% to 2.7% to meet the EU target. The suspicion was that, well, it hadn’t exactly cut the deficit but, among other things, it had used derivatives to provide window dressing. There were suspicions that other EU countries also used similar structures to fiddle their books to meet the Maastricht criteria.

A key element of the recent Greek debt problems has been the use of derivative transactions to disguise the true level of its borrowing.

The Greek transactions undertaken with Goldman Sachs and other dealers are believed to be similar cross-currency swaps linked to the country’s foreign currency debt, structured with off-market rates. The swaps are believed to have notional principal of approximately $10 billion with maturities between 15 and 20 years. The transactions were structured to provide Greece with funding.

More recently, similar structures have emerged in Latvia where Deutsche Bank arranged a 567 million lati ($1.086 billion) financing for Riga in June 2005 using a series of contracts, augmented with currency and credit default swaps. The bank is alleged to have claimed that the transaction would not count as debt.

This follows a series of revelation regrading the use of derivatives by municipal authorities in the U.S., Italy, German, Austria and France where complex bets on interest rates were used to provide funding or cosmetically lower borrowing costs. Many of these transactions resulted in substantial losses and are now in dispute.

Other financial products can also be used to reduce the level of reported debt. These include securitisation of future public sector receipts, the use of non-consolidated borrowing institutions, private-public financing arrangement supported indirectly by the State and leasing rather than direct ownership of assets. Greece may have also used some of these arrangements.

Whether illegality is involved has not been established. However, at a minimum, the arrangements raise important questions about public finances and financial products.

The episodes raise questions of the skills of regulators and reporting agencies in understanding and dealing with financial structures. They highlight inadequacies of public accounting.

Reported debt statistics fail to provide adequate information of the level of borrowing, the real cost of debt and also the future repayment commitments. Under international standards, such an off-market swap would have had to be accounted for by public corporations on a mark-to-market requiring greater disclosure of the details, especially the large negative market value (representing future payment obligations) as a future liability.

For example, the real effect of the Greek transaction is not clear. Analysts suggest that the cash received from the transactions may have reduced the country’s debt/GDP ratio from 107% in 2001 to 104.9% in 2002 and lowered interest payments from 7.4% in 2001 to 6.4% in 2002. However, the large negative market value of the currency swaps (representing future payment obligations) does not appear to have been reported as a future liability for Greece.

Such arrangements provide funding for the sovereign borrower at significantly higher cost than traditional debt. For example, in the Greek swaps, these costs include charges for counterparty credit risk in the swap and hedging costs for the interest rate and currency risk. In addition, the cash bears a higher rate than the normal credit margin on the sovereign’s debt. In part, this reflects the premium for an illiquid loan compared to a more liquid, tradeable conventional bond.

The true cost to the borrower and profit to the counterparty is also not known, due to the absence of any requirement for detailed disclosure in derivative transactions. Goldman Sachs and other dealers reputedly earned hundreds of millions of dollars from these transactions.

The structures described as also used extensively to cover up existing losses on other transactions. Such arrangements are not unknown in Indian markets where participants with loss making positions have resorted, knowingly or unknowingly, to such techniques to avoid recognising the problem.

Normal commercial transactions can be readily disguised using derivatives exacerbating risks and reducing market transparency. Current proposals to regulate derivatives do not focus on this issue. The policy case for permitting these types of applications of derivatives is not clear.

Such derivative schemes are neither “beautiful” nor “true”. Legislators and regulators should perhaps ponder these issues.

© 2010 Satyajit Das All Rights reserved.

Satyajit Das is the author of the Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2010)

Dr. Jekyll and Mr. Hyde Finance

About one year ago, AIG was brought to the brink of bankruptcy as a result its exposure under credit default swaps (“CDS”) (a form of credit insurance). Asset backed securities and Collateralised Debt Obligations (“CDOs”), which lived up to its cheery nickname Chernobyl Death Obligation, brought the financial system to the edge of collapse.

Volatile equity and currency markets caused problems with exotic option “accumulators” (known to traders as “I-will-kill-you-later”). Numerous investors and corporations are bunkered down with their lawyers hoping to litigate their way out of significant losses on “hedges” pleading familiar defenses – “I did not understand the risks” or “I was misled about the risks by the bank”.

If you assumed that these events meant that wild beast of derivatives would be tamed, then you would be wrong. History tells us that there will be cosmetic changes to the functioning of the market but business as usual will resume in the not too distant future. Problems with derivative problems of portfolio insurance in 1987 and Long Term Capital Management (“LTCM”) in 1998 did not lead to fundamental changes in the operation of derivatives markets.

Tried and faied initiatives (based on particular religious convictions) will be prompted including improving disclosure, increasing capital and implementing a new centralised counterparty (“CCP”) to attemnpt to reduce the risk of a major dealer failing. Fundamental issues - the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems - will not be substantively addressed.

The industry and its key lobby group (ISDA – International Swaps & Derivatives Association) are well practiced in the art of regulatory skullduggery.

Derivatives, it will be argued, are 'soooo' complicated that only derivative traders themselves can properly “regulate” them. If this fails then there will be more subtle rhetorical thrusts.

The new CCP is only for “standardised” derivatives. Already, there are impassioned semantic debates about what is meant by “standard derivatives” and whether they can actually be cleared through the CCP.

On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: “Not all standardized contracts can be cleared.” He argued that that even if they have standardized economic terms many derivatives contracts will be “difficult if not impossible to clear” because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make “it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.”

Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that “it may be more appropriate for products that trade less frequently to trade over-the-counter.”

The industry will argue for self-regulation, which bears the same relationship to regulation that self importance does to importance.

The reasons for policy inaction are complex. As undoubtedly numerous professors from well-known universities will testify, derivatives do perform important risk transfer functions within modern capital markets – the Dr.Jekyll side of derivatives. ISDA’s Pickel laid out this argument with eloquent panache arguing against standardisation and the CCP as it “would undercut their very purpose: the ability to tailor custom risk-management solutions to meet the needs of end-users.”

Derivatives by their inherent nature are also have a Mr.Hyde side. The ability to use derivatives to speculate, create off-balance sheet positions, increase leverage, arbitrage regulatory and tax rules and manufacture exotic risk cocktails will continue to be a major factor in derivative activity.

The reality is that hedging and risk management is secondary to the other uses. For companies, the ability to use derivative trading to supplement traditional earnings, which are under increased pressure, is irresistible. For institutional and retail investors, the use of derivatives to improve returns through leverage and access to different risks is now a vital part of the investment process.

For banks, the Dr.Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.

The complexity of modern derivatives has little to do with risk transfer and everything to do with profits. As new products are immediately copied by competitors, traders must “innovate” to maintain revenue by increasing volumes or creating new structures. Complexity delays competition, prevents clients from unbundling products and generally reduces transparency. Frequently, the models used to price, hedge and determine the profitability also manage to confuse managers and controllers within banks themselves allowing traders to book large fictitious “profits” that their bonuses are based on.

The sheer importance and size of derivative profits means that it will continue to attract the best and the brightest who will continue to play these time honoured games.

Warren Buffet once described bankers in the following terms: “Wall Street never voluntarily abandons a highly profitable field. Years ago… a fellow down on Wall Street…was talking about the evils of drugs…he ranted on for 15 or 20 minutes to a small crowd…then…he said: “Do you have any questions?” One bright investment banking type said to him: “yeah, who makes the needles?

Derivatives and debt are the needles of finance and bankers will continue to supply them to all the Dr. Jekyll’s and Mr. Hyde’s alike for the foreseeable future as long as there is a buck to be made in the trade.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

OTC Derivative Regulation Proposals – Neat, Plausible and Wrong!

Proposals for over-the-counter (OTC) derivative regulations are consistent with H. L. Mencken’s proposition that: “there is always a well-known solution to every human problem--neat, plausible, and wrong.”

A central omission is the speculative use of derivatives. Industry lobbyists focus on the use of derivatives to hedge and manage risk promoting investment and capital formation. While derivatives can play this role, the primary use of derivatives now is manufacturing risk and creating leverage.

Derivative volumes are inconsistent with “pure” risk transfer. In the credit default swap market (CDS) market, volumes were in excess of four times outstanding underlying bonds and loans. The need for speculators to facilitate markets contrasts with recent experience where they were users rather than providers of scarce liquidity and amplified systemic risks.

Relatively simple derivative products provide ample scope for risk transfer. It is not clear why increasingly complex and opaque products are needed other than to increase risk and leverage as well as circumvent investment restrictions, bank capital rules, securities and tax legislation.

A central reform proposed is the central clearing house (the central counterparty - CCP) where (so far unspecified) “standardised” derivatives transactions must be transferred to an entity that will guarantee performance.

The CCP centralises all performance in a single entity, surely the ultimate case of “too big to fail”. Effectiveness of the CCP depends on its ability to manage risk through a system of daily cash margins to secure exposure under contracts. Failure to meet a margin call requires the CCP to close out the position and offset any losses against existing collateral.

The level of initial collateral posted must cover the fall in value from the last margin call. There are inherent moral hazards in setting the initial collateral. Traders want the maximum amount of leverage by reducing the amount cash posted.

Collateral models are based on historical volatility that may underestimate risk. For some products, such as CDS contracts, establishing the required levels of collateral required is difficult. Cross margining where traders can net all open positions expose the CCP to correlation problems in the offset methodologies. Additional problems may arise from the use of multiple CCPs.

There are significant issues in pricing and valuing contract and, for some products, reliance on complex models. The CCP assumes the ability to value contracts that relies, in turn, on liquid markets in the instruments, an unrealistic condition as events have showed.

Mis-selling of “unsuitable”derivative products to investors and corporations remains a problem. Expertise of purchasers is sometime inversely related to the complexity of derivative products. Given significant information and knowledge asymmetry between sellers and buyers, the possibility of disallowing certain types of transactions altogether or with certain parties should have been considered.

Complex risk relationships created by derivatives are not addressed. AIG’s problems related to margin calls based on current “market” values on its derivative contracts. The CCP may inadvertently increase liquidity risk as more participants may be subject to margining and unexpected demands on cash resources.

Systemic effects, such as the impact of CDS contracts on risk taking behaviour and also dealing with financial distress, are ignored. Concentrated market structures, where a handful of large dealers dominate dealing, are also not addressed.

For example, the OCC in the U.S. reported that largest five banks hold 96% of total notional volume of derivatives and the largest 25 banks hold nearly 100%.

Familiar dictums - improved disclosure, transparency and operational processes - have been tried before with limited success.

The unpalatable reality that few, self interested industry participants are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits.

Until regulators and legislators understand the central issues and are prepared to address them, no meaningful reform in the control of derivative trading will be possible.

© 2009 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Credit Default Swaps – Through The Looking Glass

CDS contracts and credit derivatives are complex and powerful financial instruments that frequently have unforeseen consequences for market participants and the financial system. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: “Anyone who thinks they understand this stuff is living in lala land.”

Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by academic acolytes and fans, generally those promoting the product.

The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offers these advantages. Where not used for hedging it is not clear how this assists in capital formation and enhancing efficiency of markets.

CDS contracts also, it is claimed, improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowers trading costs. Where the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice.

Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premia, compensation for volatility of credit spreads and other factors.

CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the “negative basis trade” is predicated on pricing inefficiency.

In a negative basis transaction commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.

In early 2009, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid, a UK utility, were around 2.00% pa (200 basis points) compared to National Grid’s credit spread to government of around 3.30% (330 basis points). Similarly, Tesco, the UK retailer was exhibited CDS fees of around 1.40% (140 basis points) against a credit spread to government of around 2.50% (250 basis points).

In effect, market pricing of credit risk as between the CDS market and the bond and loan market was significantly different.

Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated “A” were trading at a higher credit spread than bonds of borrowers rated lower (say “B”) in the bond market. At the same times, CDS fees for borrowers rated “A” were trading at a lower level than CDS fees of borrowers rated lower (say “B”) in the credit derivatives market.

There are also notable discrepancies in the pricing of corporate credit risk relative to their sovereigns. In early 2009, Cadbury, the UK confectionery firm, was trading for 10 years substantially below the CDS fee of the UK government but Cadbury bonds were trading at a spread of around 2.00% (200 basis points) above UK government bonds. As people on one side of the Atlantic Ocean might remark: “Go figure!”

CDS contracts also are supposed to enhance information efficiency, improving availability of market prices for credit risk allowing more informed decisions by market participants. As CDS contracts are traded in the private OTC derivative markets, there is limited dissemination of market prices. This limits price discovery and therefore any informational benefits.

In reality, pricing and trading information is only available readily to large active dealers in CDS contracts. This informational asymmetry may advantage these dealers. Knowledge about trading flows in CDS contracts may allow these dealers to earn economic profits.

Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. CDS contracts may create additional risks within the financial system. While CDS contracts did not cause the current financial crisis (excessive reliance of debt did), they may have exacerbated the problems and complicated the process of dealing with the issues.

The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. Even this hedging application is dogged by some of the identified documentary issues that may reduce the effectiveness of CDS contracts as a hedge. Such problems may well be fundamental to the nature of the instrument and incapable of remedy, at least easily.

In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent the CDS market has detached from the underlying “real” credit market. If defaults rise then the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems.

The International Swaps and Derivatives Association (“ISDA”), the derivatives industry group, have recently implemented initiatives to “hard wire” the auction based protocols into the standard CDS documentation. They have also initiated changes in market practices, such as fixed coupons for CDS contracts, designed to facilitate trading in these instruments. These actions increasingly focus on CDS contracts as an instrument for trading on default risk and credit spreads rather than one whose primary objective is the hedging of credit risk. The latter would emphasis less standardisation and a greater focus on matching the nature of underlying bond or loan being hedged.

The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the US. The fee for hedging against losses on $10 million of Treasuries currently peaked at about 1.00% pa for 10 years (equivalent to $100,000 annually). This is an increase from 0.01% pa ($1,000) in 2007.

The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.

The unpalatable reality that very few, self interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.

In October 2008, Alan Greenspan, the former Chairman of the Fed, acknowledged he was “partially” wrong to oppose regulation of CDS. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing. This from the man who on 30 July 1998, stated that: “Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”

On 6 March 2009 Bloomberg reported that Myron Scholes, the Nobel prize winning co-creator of the eponymous Black-Scholes-Merton option pricing model, observed that the derivative markets have stopped functioning and are creating problems in resolving the global financial crisis. Scholes was quoted as saying that: “ [The] solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and … start over…” ISDA, the beleaguered derivatives industry group, predictably countered limply that: “… the notion that you would, as he said, blow up, the business in that way is just misguided.”

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Credit Default Swaps – Exercises in Surrealism

At the quantum level, the laws of classical physics alter in intriguing ways. In financial markets, at the derivative level, the rules of finance also operate differently.

The derivative industry’s indefatigable advocacy of credit default swaps (“CDS”) centers on the fact that contracts related to recent defaults settled and the overall net settlement amounts were small. Closer scrutiny suggests causes for caution.

The CDS contract is triggered by a “credit event”; broadly, default by the reference entity. CDS contracts on Freddie and Fannie were ‘technically’ triggered as a result of the conservatorship necessitating settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion. Government actions were specifically designed to allow the firms to continue fully honouring their obligations. Triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

Practical restrictions on settling CDS contracts has forced the use of “protocols” – where counterparties may substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an “auction” system.

For the GSEs, the auction prices resulted in the following settlements by sellers of protection: Fannie Mae – around 8.49% for senior debt and 0.01% for subordinated debt. Freddie Mac – around 6.00% for senior debt and 2.00 % for subordinated debt.

Subordinated debt ranks behind senior debt and is expected to suffer larger losses in bankruptcy. The lower payout on subordinated debt probably resulted from subordinated protection buyers suffering in a short squeeze resulting in their contracts expiring virtually worthless. Differences in the payouts between the two entities are also puzzling given that they are both under identical “conservatorship” arrangements and the ultimate risk in both cases is the US government.

In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large relative to historical default loss statistics. This may reflect poor economic conditions but are more likely driven by technical issues related to the CDS market.

For example, the Washington Mutual payout (around 43%) may have been affected by capital remaining at the holding company, Washington Mutual Inc. (estimated at $2.8 billion). More recently, the auction settlement of Lyondell (around 80-85%) reflected complication from the role of debtor in possession financing and complex collateral allocation mechanisms.

Skewed payouts do not assist confidence in CDS contracts as a mechanism for hedging. In addition, the large payouts are placing a material pressure on the price of underlying bonds and loans exacerbating broader credit problems.

Low overall net settlement amounts may also be misleading. In practice, there are actually two settlements. The ‘real’ settlement where genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds and were hedging). The ‘auction’ where dealers who have both bought and sold protection and have small net positions settled via the auction.

In the case of Lehman Brothers, the net settlement figure of $6 billion that was quoted refers to the auction. Some banks and investors that had sold protection on Lehmans did not participate in the auction choosing to take delivery of defaulted Lehman debt resulting in losses of almost the entire face value.

CDS contracts can amplify losses in credit market. Lehman Brothers defaulted with around $600 billion in debt implying a maximum loss to creditors of that amount. In addition, according to market estimates, there were CDS contracts of around $400-500 billion where Lehmans was the reference entity.

Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250-350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200-300 billion) are additional to the $600 billion. The CDS contracts amplified the losses as a result of the bankruptcy of Lehmans by (up to) approximately 50%.

The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. A lender with purchased protection may seek to use the restructuring to trigger its CDS contracts.

As the global economy slows and the risk of corporate default increases sharply, the identified issues with CDS contracts are likely to complicate the problems of credit markets and banks generally.

In October 2008, Alan Greenspan, the former Chairman of the Fed, acknowledged he was “partially” wrong to oppose regulation of CDS. “Credit default swaps, I think, have serious problems associated with them,” he admitted to a Congressional hearing.

Ludwig von Mises, the Austrian economist from the early part of the twentieth century, once noted: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating his premises”.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

Tales of Leverage

There is widespread recognition that the benign conditions of recent years encouraged a sharp increase in the leverage within the financial system. The build-up of leverage this time around entails a number of surprises. New financial techniques have supplanted lending as the primary source of liquidity and leverage creation reflecting Will Rogers’ droll observation: “You can't say that civilization don't advance; for in every war they kill you a new way.”

Traditional leverage, in the form of borrowings, remains important. A major area of growth has been collateralised lending where holders sell assets against the agreement to re-purchase it at a future date. Growth of hedge funds and prime brokers has fueled explosive growth in collateral and expanded the range of assets against which funding can be raised. Substantial sums can be raised against any type of security or instrument, complementing the long established government bond repo markets.

The borrower posts an initial margin or “haircut” (a small amount of his money) and promises to post more cash if the value of the asset declines. Favourable regulatory rules, optimistic views of liquidity (the collateral must be sold if the borrower fails to pay) and faith in the models used to set the initial margin are driving aggressive use of collateral increasing available liquidity and leverage.

Derivatives have contributed to the sharp rise in leverage. Derivative structures have increased leverage in two ways.

The first is the “derivatisation” of lending. For example, the purchase of $10 million of shares requires commitment of cash. The trader can instead enter a total return swap (“TRS”). Under the terms of the swap (see Diagram below) he receives the return on the share (dividends and increases in price) in return for paying the cost of holding the shares (decreases in price and the funding cost of the dealer). The TRS requires no funding other than any collateral required by the dealer; this is substantially less than the $10 million required to buy the shares. The trader acquires the same exposure as buying the shares but increases its return through leverage. In effect, the loan to the investor secured over the asset has been repackaged as a derivative transaction enhancing the leverage.

The second way in which derivatives can be used is to create embedded loss leverage. For a given event, you increase your potential gain or loss. Two examples – digital options (a common form of exotic derivative) and credit leverage in collateralised debt obligations (“CDOs”) – illustrate the idea.

Under a normal option to buy shares at $100 (the strike), if the shares at expiry of the option are above $100, the gain is equal to the share price minus $100; if the share price is $110, then the purchaser of the option makes and the seller loses $10. In a digital or binary option, the parties can agree that if the share price is above $100, then the option payoff is $25. If the option is in-the-money (above the strike price of $100) then the gain to the buyer and loss to the seller is the fixed $25, irrespective of whether the share price is $100.01 or $200. In effect, for a relatively small move in the share price (from $100 to $100.01), the option buyer gains and the option seller losses $25 (25% of the value of the share) effectively embedding tremendous sensitivity (i.e. leverage) to price movements.

Digital options enable traders to nominate large payouts to take leveraged positions on price movements. Declining market volatility in recent years has meant that traders generate larger premiums by increasing the size of their wagers.

The equity tranche of collateralised debt obligations (“CDOs”) is an example of loss leverage in credit markets. A typical CDO consists of a $1,000 million portfolio made up of $10 million exposure to 100 corporations. The equity investor assumes the first 2% ($20 million) of losses on the portfolio. Assuming a loss of $6 million if any corporation defaults (recovery rates are 40% of $10 million), the equity investor is taking the risk of the first three defaults. In contrast, if the investor invested $20 million in the entire portfolio ($200,000 per corporation), then three defaults in the portfolio would result in the investor losing $0.36 million (loss of $120,000 per company ($200,00 adjusted for 40% recovery rates) times 3). For three losses the equity tranche investor’s leverage to defaults is 56 times (if there were 3 losses then the investors loses the entire $20 million invested in the CDO equity against $0.36 million in the diversified portfolio). By reducing the “tranche width” (the size of the equity tranche) the credit leverage can be increased to over 83 times!

Increasing the amount of potential gain or loss for a given event is now routinely used to create leverage. The use of these techniques is poorly understood. It does not show up in traditional leverage measurements that are focused on the level of borrowings. The additional liquidity and leverage creates complex chains of risk and moral hazard in markets that may prove problematic when prices correct. It is another unknown unknown of modern markets.

As Wells Fargo CEO John Stumpf observed: “It’s puzzling why bankers have come up with these new ways to lose money when the old ways were working so well.”

© Satyajit 2008

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

The Credit Default Swap (“CDS”) Market – Will It Unravel?

In May 2006, Alan Greenspan, the former Chairman of the Fed, noted: “The CDS is probably the most important instrument in finance. … What CDS (credit default swaps) did is lay-off all the risk of highly leveraged institutions – and that’s what banks are, highly leveraged – on stable American and international institutions.” It will be interesting to see whether reality proves to be different.

The CDS is economically similar to credit insurance. The buyer of protection (typically a bank) transfers the risk of default of a borrower (the reference entity) to a protection seller who for a fee indemnifies the protection buyer against credit losses.

The CDS contract and the entire Structured Credit Market originally was predicated on hedging of credit risk. Over time the market changed focus – in Mae West’s words: “I used to be Snow White, but I drifted.” The ability to short credit, leverage positions and trade credit unrestricted by the size of the underlying debt market have become the dominant drivers of growth in the market for these instruments.

The CDS market has grown exponentially to current outstandings of around US$ 50 trillion. Even eliminating double counting in the volumes, the figures are impressive, especially when you considered that the market was less than US$1 trillion as at 2001. However, the size of the market (which has attracted much attention) is not the major issue.

Banks have used CDS contracts extensively to hedge credit risk on bonds and loans. The key issue is will the contracts protect the banks from the underlying credit risk being hedged. As Mae West noted: “An ounce of performance is worth pounds of promises.” Documentation and counterparty risk means that the market may not function as participants and regulators hope if actual defaults occur.

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought. In fairness, all financial hedges display some degree of mismatch or “basis” risk.

The CDS contract is triggered by a “credit event”, broadly default by the reference entity. The buyer of protection is not protected against “all” defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan. Some credit events like “restructuring” are complex. There are different versions – R (restructuring); NR (no restructuring); MR (modified restructuring); MMR (modified modified restructuring). Different contracts use different versions.

“PAI” (publicly available information) must generally be used to trigger the CDS contract. Recent credit events have been straightforward Chapter 11 filings and bankruptcy. For other credit events (failure to pay or restructuring), there may be problems in establishing that the credit event took place.

This has a systemic dimension. A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract. A study by academics Henry Hu and Bernard Black (from the University of Texas) concludes that CDS contracts may create incentives for creditors to push troubled companies into bankruptcy. This may exacerbate losses in case of defaults.

In case of default, the protection buyer in CDS must deliver a defaulted bond or loan – the deliverable obligation – to the protection seller in return for receiving the face value of the delivered item (known as physical settlement). When Delphi defaulted, the volume of CDS outstanding was estimated at US$28 billion against US$5.2 billion of bonds and loans (not all of qualified for delivery). On actively traded names CDS volumes are substantially greater than outstanding debt making it difficult to settle contracts.

Shortage of deliverable items and practical restrictions on settling CDS contracts has forced the use of “protocols” – where any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller of protection makes a payment to the buyer of protection. The payment is intended to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through a so-called “auction system”. The auction is designed to be robust and free of the risk of manipulation.

In Delphi, the protocol resulted in a settlement price of 63.38% (the market estimate of recovery by the lender). The protection buyer received 36.62% (100% - 63.38%) or US$3.662 million per US$10 million CDS contract. Fitch Ratings assigned a R6 recovery rating to Delphi’s senior unsecured obligation equating to a 0-10% recovery band - far below the price established through the protocol [see James Batterman and Eric Rosenthal Special Report: Delphi, Credit Derivatives, and Bond Trading Behavior After a Bankruptcy Filing (28 November 2005); www.fitchratings.com].

The buyer of protection depending on what was being hedged may have potentially received a payment on its hedge well below its actual losses – effectively it would not have been fully hedged.

The settlement mechanics may cause problems even where there is no default. One company refinanced its debt using commercial mortgage backed securities (“CMBS”). The company was downgraded by rating agencies. A shortage of deliverable obligations (the company used the funds from the CMBS to repay its bond and loans) meant that the CDS fee for the company fell sharply (indicative of an improvement in credit quality). This resulted in mark-to-market losses for bemused hedgers. This is known in the trade as an “orphaned CDS”.

In the case of actual defaults the CDS market may provide significant employment to a whole galaxy of lawyers trying to figure out whether and how the contract should work. There is the risk that contract may not always provide buyers of protection with the hedge against loss that they assumed they would receive.

CDS contracts substitute the risk of the protection seller for the risk of the loan or bond being hedged. If the seller of protection is unable to perform then the buyer obtains no protection.

Currently, a significant proportion of protection sellers is financial guarantors (monoline insurers) and hedge funds. Concerns about the credit standing of monolines are well documented. Recently, a number of banks took charges against counterparty risk on hedges with financial guarantors including Merrill Lynch (US$ 3.1 billion) Canadian Imperial Bank of Commerce (“CIBC”) (US$2 billion) and Calyon (US$1.7 billion).

For hedge funds, the CDS is marked-to-market daily and any gain or loss is covered by collateral (cash or high quality securities) to minimise performance risk. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. In practice, banks may not be willing or able to close out positions where collateral isn’t posted.

ACA Financial Guaranty sold protection totaling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement. The banks have agreed to a “forbearance agreement” whereby the buyer of protection waived the right to collateral temporarily. ACA subsequently has been downgraded to “CCC” reducing the value of the CDS contract and the protection offered. The problems at ACA are not unique.

A critical element is the level of over-collateralisation. The buyer of protection will want an initial margin to cover the risk of a change in the value of the contract and the failure by the seller of protection to meet a margin call. The seller of protection wants to increase leverage by reducing the amount of cash it must post as initial margin. It is possible that the level of initial collateral may prove be too low. Collateral models use historical volatility and correlation that may underestimate the risk. The entire process also assumes liquidity in the underlying CDS market that may be absent in a crisis.

CDS contracts entail significant operational risks. Delays in documenting CDS contracts forced regulators to step in requiring banks to confirm trades more promptly. Where collateral is used, there are additional challenges of the accuracy of mark-to-market of CDS and monitoring of collateral.

If the CDS contracts fail then “hedged” banks are exposed to losses on the underlying credit risk. Recently, one analyst suggested that losses from failure of CDS protection sellers to perform could total between US$33 billion and US$158 billion [Andrea Cicione “Counterparty Risk: A Growing Cause of Concern” (25 January 2008) Credit Portfolio Strategy - BNP Paribas Corporate & Investment Banking]. This compares to the around US$110 billion that banks have written off to date. While it may be unlikely that the CDS market will fail entirely it is possible that losses on the hedges will add to the losses that the banks have already incurred.

The CDS market entails complex chains of risk. This is similar to the re-insurance chains that proved so problematic in the case of Lloyds. The CDS markets have certain similarities with the reinsurance markets. The CDS fees like the reinsurance premiums are received up front. In both cases the risks are both potentially significant and “long tail” – they do not emerge immediately and may take some time to be fully quantified. As in the re-insurance market, the long chain of CDS contracts may create unknown concentration risks. Defaults may quickly cause the financial system to become gridlocked as uncertainty about counterparty risks restricts normal trading.

The impact of a bankruptcy filing by Bear Stearns on the OTC Derivatives market, including the CDS, was probably one of the factors that influenced the Federal Reserve and US Treasury’s decision to support the rescue of the investment bank. Barclays Capital recently estimated that the failure of a dealer with $2 trillion in CDS contracts outstanding could potentially lead to losses of between $36 billion and $47 billion for counterparties. This underlines the potential concentration risks that are present.

Over the last year, securitisation and the CDO (collateralised debt obligation) market have become dysfunctional. As the credit crisis deepens, the risk of actual defaults becomes real. Analysts expect the level of defaults to increase. The CDS market is about to be tested. While there have been a few defaults, the market has not had to cope with a large number of defaults at the same time. CDS contracts may experience problems and may be found wanting.

CDS contracts may not actually improve the overall stability and security of the financial system but create additional risks.


At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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.