Derivatives Strategy Hall of Fame 1997
How Leo Melamed, Myron Scholes, Richard Sandor and Allen
Wheat helped create the derivatives market-and turned the financial world
For Leo Melamed, the key inspirational event was a rebuff from a commercial bank. He wanted to make a play on the dollar in 1973 but was told he couldn't
trade currencies without a commercial interest. The result: the first exchange-traded
For Myron Scholes, it was the intellectual curiosity about options he
shared with colleague Fischer Black at a Thursday evening finance workshop
at MIT. The resulting collaboration was what Nobel Prize-winning economist
Merton Miller calls "one of the most important intellectual achievements
of the latter part of the 20th century."
Richard Sandor created interest rate futures from a growing conviction
that the burgeoning market in government debt would create an enormous demand
for hedging products. And Allen Wheat left a treasury job at General Foods
to market interest rate swaps at Bankers Trust because, he admits frankly,
it was a great chance to make some money.
In the following pages, we profile the first four members of the Derivatives Hall of Fame, honoring the people who have made major contributions to the
derivatives market. Their biographies chronicle the tough beginnings in
Chicago in the 1970s, the birth of the OTC market in the 1980s, the expansion
into new markets and, finally, the explosion of new instruments and techniques
in the 1990s.
The Father of Financial Futures.
Leo Melamed is without a doubt one of the most colorful characters in
finance. Never without a trenchant opinion or a good story, the chairman
emeritus of the Chicago Mercantile Exchange has been a moving force in financial
futures since he introduced foreign currency futures in 1972.
But Melamed is no ivory tower operator. He's been a floor trader since
1960 and now runs Sakura Dellsher, a global futures joint venture between
the Japanese bank Sakura and Dellsher Investment Co., a futures commission
merchant established by Melamed in 1965. Melamed's days wouldn't be complete
without a trip to the trading floor and a bit of hands-on activity.
Melamed took a rather circuitous route to his position as the grand old
man of financial futures. He trained as a lawyer, picking up a runner's
job on the Merc for a bit of extra cash while in school. He worked his way
up the ranks on the exchange, but in the interest of security-"I had
a wife and child"-Melamed continued to practice law until 1965. "I
wasn't a very good trader during that period-I'd gone broke twice in the
process," he concedes. "In the back of my mind I knew that I didn't
have the discipline to be successful part-time. Very few part-time traders
who do it as a hobby make it. So in 1965 I made the decision to treat it
as a profession, a full-time business, and find out if I had any real talent."
As it turned out, Melamed had plenty of talent. More important, his legal training gave him an instant insight to what was lacking at the Merc. "Futures
were the distant black sheep in the family of finance," he recalls.
"For good reason. The Merc was a jungle with no rules, a place where
innocents were fleeced routinely." He took over leadership of the exchange
in 1967 and began the long process of establishing a body of rules and regulations
for the running of the exchange.
He cites three points of pride in bringing the Merc into the modern world. "We wrote rules and we proved that we meant to enforce these rules,"
he says. Thus the Merc changed from the so-called "Whorehouse of LaSalle
Street" to a free-market exchange with credibility.
"During the early 1960's a group of us at the Merc looked around
us and saw stagnating markets and stagnating people who didn't have a lot
of new ideas," recalls Barry Lind, a partner at Lind Waldock. "We,
however, had plenty of new ideas and we wrestled power from the establishment.
Leo led that process."
"Leo's greatest strength is being able to recognize secondary reactions," adds Brian Monieson, chairman of GNP Commodities, and former chairman of
the Chicago Mercantile Exchange. "He can predict the reaction to a
reaction. In the Chicago riots of 1968, everyone predicted that Chicago's
mayor would take tremendous abuse and criticism from the press. But Leo
also correctly predicted a secondary reaction: there would be a very positive,
secondary reaction for Daley from the people who were silent during the
protests. This ability to analyze the reaction is what impressed me most
With credibility came an explosion in interest in the Merc's products.
"As the floor became crowded, we had to think about expansion,"
says Melamed. He masterminded the Merc's1973 interim move to 444 West Jackson
and the 1984 relocation to its spacious premises on West Madison at the
Melamed's fondest memory is the development of the International Monetary Market, the offshoot of the Merc that in 1973 started trading the world's
first financial futures-foreign exchange futures. "I was very conscious
that an exchange needed a diversity of products to survive. My first experience
had been trading eggs, which in the early 1960s, before 24-hour egg production,
was a seasonal business. When 24-hour production came in, there was no need
for egg futures; there was no volatility in the price. You can't survive
as an exchange on one product," he says.
In thinking about the prospects for diversification and the Merc, he
lit on foreign currencies, for several reasons. "I watched the sterling
crisis, the dollar crisis, the breakdown of Bretton Woods. And I was reading
the economist Milton Friedman on the value of a floating rate exchange system.
Then a friend mentioned a corporate hedging transaction that had made his
company money. When I tried to do a similar transaction, I was told by the
commercial bank that I approached that I needed a commercial interest to
hedge currency. I didn't have such an interest, so I couldn't do the deal.
So I saw the possibilities for a new kind of product on the exchange,"
With a paper written by Friedman endorsing the concept, Melamed hit the
road, criss-crossing the country and the globe proselytizing on the beauty
of foreign currency futures. He met a hostile response, but persevered.
"The timing was perfect. After we launched the foreign currency contracts,
inflation hit and the oil crisis. It was a perfect opportunity to make money,"
This early foray into financial futures was followed by many others at
the Merc, but Melamed remains a bit sentimental about the foreign exchange
futures. "I've traded them all-T-bills, eurodollars, the S&P index.
But the best is currency futures," he says.
The next big landmark for Melamed was the evolution of financial futures to cash settlement. "Without cash settlement, which evolved out of
the eurodollar contract that was developed in the late 1970s, the rest of
the derivatives business just couldn't have happened," says Melamed.
At the time the Commodities Futures Trading Commission required physical settlement of all futures contracts. With eurodollars, of course, there
isn't anything to produce at the end of the day. Melamed was instrumental
in convincing the CFTC that the idea of cash settlement wasn't the same
as pure gambling. "With that development, the sky was the limit. It
spawned the derivatives world because most products have no deliverable
in physical form," says Melamed.
As far as the future is concerned, Melamed has no doubt that technology
is the leading force in futures and derivatives. "There are too many
exchanges today," he predicts. "Some will go out of business and
should because of technology. Even in the open outcry environment, technology
will be used to keep this type of trading viable. Even in 1987, when I led
the fight for GLOBEX, I said that the black box ought not be feared."
Is he disappointed that GLOBEX hasn't made the impact once hoped? "It's grown slower than I would have hoped," he admits. "But part of
that is the political problem between the Merc and the CBOT. Electronic
exchanges will continue to allow traders in different time zones access
to the volume and liquidity of other contracts. But rather than destroy
local markets, it will drive local markets to develop local products."
Richard Sandor, chairman and CEO of Centre Financial Products,
has had his hands in interest rate futures, insurance derivatives and electronic
trading. Now he's concerned about derivatives on natural resources like
air and water.
When Sandor was a young economics professor in the 1960s at the turbulent Berkeley campus of the University of California, he could see that change
was in the air. But Sandor saw more than the social upheavals around him.
"You didn't have to be at all smart to see that the game of stable
interest rates and unbroken economic growth was up," he says. His crystal
ball suggested three revolutionary ideas indicative of social change in
the economy. One was futures on interest rates-the idea Sandor is best known
for. The next involved the commoditization of the insurance business. The
third concerned the ability of electronic trading to alter the behavior
Of these three, it was electronic markets that first moved him out of
the academy, as he investigated the possibility of setting up a fully electronic
stock market in San Francisco in the 1960s. The idea was way ahead of its
time-and was dismissed as technologically impractical.
Sandor soon made his mark in Chicago as the first economist on the staff of the Chicago Board of Trade (CBOT). It was a prescient appointment. In
1972, the U.S. economy changed forever. Inflation heated up, grain markets
went wild and the prime rate started "bursting at the seams,"
recalls Sandor. "For years, I had heard that there was no need to hedge
interest rates. There was no volatility, so there was no need for interest
rate futures. Then that world view began to creak a little."
Over at the Chicago Mercantile Exchange, currency futures were just getting started. But that didn't make Sandor's selling job any easier. "Bonds
were a minor part of Wall Street's business before 1973-only Salomon Bros.
had any real experience in fixed income," says Sandor. In his travels
to promote the idea of interest rate futures, the only interested parties
were the savings and loans and mortgage bankers-and Salomon. "They
could see their own need for these products," he says.
But financial futures were very new products and it wasn't at all clear
who would regulate these new beasts. There commenced a few years of wrangling
with the old Commodity Exchange Authority, which decided it couldn't regulate
interest rate futures because, says Sandor, "they weren't an agricultural
product." The Securities and Exchange Commission didn't want them either,
since they weren't securities. Eventually the Commodity Futures Trading
Commission was born, and with it an ongoing tussle for jurisdiction over
"Until the day before the Ginnie Mae future started trading on October 20, 1975, there was regulatory uncertainty," he recalls. "Though
the CFTC legislation gave it jurisdiction over commodities, tangible and
intangible, the SEC still planned to put in an injunction to prohibit trading
in the new contract until the day before the launch."
Acceptance came slow during the first few years. "The turning point for financial futures," says Sandor, "was the Saturday Night Massacre
in October 1979, when then-Federal Reserve Chairman Paul Volker let interest
rates float free. After that there was no turning back from innovative ways
to hedge interest rates."
"When Richard came to the Board of Trade, the United States was
becoming a debtor nation and issuing increasing quantities of debt securities,"
explains Les Rosenthal, managing partner, Rosenthal Collins Group and former
chairman of the Chicago Board of Trade. "Richard's inspiration was
to see this trend and to suggest futures on government debt. When futures
on Ginnie Mae's didn't succeed, he came up with futures on the long bond,
which became the most successful futures contract in history.
All through this early period, the New York stock exchanges wanted to
capture some of Chicago's action. But New York, says Sandor, would never
be able to take away Chicago's natural advantage. "I cannot overemphasize
this: a market is a natural monopoly and there is an enormous first-mover
effect," he says. "As liquidity goes up, costs go down and it
is almost impossible to turn this around." A native New Yorker who
has now relocated permanently to Chicago, Sandor admits this a bit wistfully.
He has his fans back home though. Sandor never gave up on his early ideas about insurance derivatives. In the late 1980s, CBOT chairman Rosenthal
approached Sandor to devise an insurance contract. This novel and exciting
instrument debuted in 1992, but not before Sandor endured a rerun of the
battle to launch the interest rate futures. "They said, 'There's no
need for insurance futures contracts. You don't have to transfer risk,'"
recalls Sandor. "Then Hurricane Hugo and the San Francisco earthquake
What turned the tide in the development of this product, says Sandor,
was the recognition that an enormous amount of capital was required to handle
intermittent property and casualty risk. "In the United States, there
has been a demographic change in the last 20 years. All the considerable
new wealth in the United States was created in coastal areas, which are
high-risk catastrophic areas. And environmental concerns and legislation
had changed the ticket price for catastrophes. The insurance industry was
caught by both of these developments and it left a hole in the capacity
of the industry to cope. Part of that will be filled by Bermudan companies,
part by Wall Street and part in Chicago."
The catastrophe contract, after a redesign last year, is beginning to
pick up volume at the CBOT, but Sandor is already off to new frontiers.
One, of course, is electronic trading, another idea that fascinated him
since the '60s. As second vice chairman of the CBOT, he's in charge Project
A, the exchange's latest off-hours electronic platform.
He's even developed a new area of interest-scarce free resources. "It's so simple," says Sandor. "We are running out of clean water and
air. So how do you plan for the future? You have two choices-solve by command
and control, or use a market-based solution." Guess which one Sandor
Earlier in the decade, Sandor was instrumental in developing the first
spot and futures markets in environmental contracts for the CBOT. Today
he is an expert adviser to the United Nations on the tradable entitlements
for carbon dioxide.
Sandor hasn't put his innovating days behind him. "In today's environment, where inflation is under control and the government has plans to reduce
the deficit, the challenge will be to make up for the decrease in the trading
volume that these changes could cause," says Rosenthal. "Richard
is looking at a lot of new ideas, including possibly index-based futures
on housing starts and a new approach to electricity futures. Nobody expects
any of these products to be as immediately successful as the bond contract,
but taken together they could go a long way toward picking up the slack."
Does he have anything else up his sleeve? As Chairman of Centre Financial, an affiliate of Centre Reinsurance, he's busy developing and trading new
insurance derivatives products. But if he can find the time, Sandor wants
to be involved in the total revolution of the property market. Don't try
to keep up, unless you've got lots of energy-or can purchase an option on
Sandor's future energy reserves.
The Scholes in Black-Scholes has always looked beyond academe
to new challenges.
Myron Scholes is not a household name. But few in the derivatives world
are unaware of his work. They know it in the form of the Black-Scholes options
pricing model. The seminal paper, written with the late Fischer Black, was
published early in Scholes' career in 1973, when he was a 32-year-old finance
professor at MIT's Sloan School of Management. He's also been designated
by his peers as deserving of the Noble Prize in economics for the Nobel
Prize in economics.
But ask Myron Scholes about the effect of this paper on his life and
he laughs. "Obviously in terms of my career, it was very important,"
he says. "You always think all your kids are great. And that's true
of my work. But some kids are more successful than others.
Scholes is now a principal at Long Term Capital Management, a Greenwich, Conn. money management firm, where he is able to put some of his ideas and
models into practice. It doesn't mean that he's left teaching forever. "I
loved the academic world," he says. "But I wanted to try to implement
some of my ideas. Each is fine."
He's obviously analyzed the differences. "In the academic world,
you address larger problems," he explains. "You make many assumptions
before you model. It's a bigger picture you are addressing. In the applied
world, the problems are more context-specific. You model all the frictions,
costs and details. It is smaller, but richer."
Option theory is only one of Scholes' preoccupations. An academic star
from an early age, certain themes run through his work. "What led me
to thinking about options pricing and discussing it with Fischer was thinking
about arbitrage, looking at how certain securities look and act like other
securities," he says. "For instance, in corporations with risky
debt levels, the equity holders have an option to repurchase the debt."
The story behind his famous collaboration with Fischer Black is a curious one. In 1968, when the two met in Boston, Scholes had just arrived at MIT
and Black was a consultant at Arthur D. Little. Black had been struggling
for three years with a model to value options that wasn't working. It was
a mark of the breadth of Black's intellectual preoccupations that he took
up this key economic and finance question even though as a mathematician
and physicist he had never taken an economics or finance class.
The two met on a Thursday evening finance workshop, and Scholes admitted that he had been trying to solve the same problem. The two soon began their
fruitful collaboration. Eventually, thanks to a push from another key figure
in finance, Robert C. Merton, then teaching economics at MIT, Black and
Scholes submitted their article on valuing options to the Journal of Political
Economy in 1970. It was turned down because of its emphasis on finance at
the expense of economics. It took three more years and the intercession
of several Chicago faculty members before the article was finally published.
The Black-Sholes model's contribution to finance cannot be overstated.
"Scholes' model is probably the most frequently used model in finance,
perhaps in all of economics," says Robert Jarrow, professor of finance
at Cornell University and director of research for Kamakura Corp. "It
was certainly one of the most successful applications of economic theory
to real-life practice in the derivatives world, and it has led to the introduction
of many new financial instruments, which can be priced according to their
"In addition to his contribution to the Black-Scholes model, Myron
has produced a very large and distinguished body of intellectual work,"
says Merton Miller, the Nobel-prize winning economist who served as chairman
of Scholes' thesis committee at the University of Chicago. "Of course,
the Black-Scholes model was one of the most important intellectual achievements
of the latter part of the 20th century. Sometimes it's hard for the public
to understand an abstract innovation like this but, like any great piece
of hardware, the Black-Scholes model spawned an entire industry by allowing
people to price securities based almost entirely on quantifiable, observable
Thinking about arbitrage led Scholes beyond the Black-Scholes model to
consider how risk is compensated in the market, the effect of dividend policies
on stock returns and, lately, how taxes change the behavior of securities
in markets. He's always been fascinated by the tension between the rules
that govern functions and the rules that govern institutions.
This explains a seeming anomaly in his curriculum vitae. Although he
has all the expected degrees-BA in economics, MBA in finance and Ph.D. in
economics-and has taught economics for three decades, he has also served
on the faculty of Stanford Law School. His fascination with law is connected
to the fascination with arbitrage. "The law characterizes a set of
institutional rules that are different from the functional rules,"
he explains. "I am, by nature, a functionalist. But I need to understand
the institutional rules and how they change function." His long-time
interest in law is also connected with his work on other constraints within
the free-market system, such as taxes and the promulgation of information.
Scholes' prolific output on these and other subjects means that he has
been in constant demand in the private sector, long before he joined Long
Term Capital Management in 1994. For the three previous years, he was a
senior adviser and managing director at Salomon Bros. Government institutions
from the Federal Reserve Board to the U.S. Treasury have also sought his
services. And the list of financial institutions and corporations that have
used his services is long.
Would Scholes' ideas have had such an impact without the proliferation
of the computer? Probably not. "The Black-Scholes model can be used
to price options on a piece of paper, but the computer allows banks and
financial institutions to use it and other models in everyday derivatives
use," he says. "Finance would be much coarser without the computer."
In particular, risk would be harder to manage and securities could not
be as finely made. "With the computer, products can be synthesized
more accurately. But you still need very sophisticated people to understand
the process. I could still build an Edsel, even with all this computer power."
Scholes' greatest regret is the passing of Fischer Black, with whom he
collaborated on a number of academic papers and consultancy projects over
the years. "His contribution was fantastic," says Scholes. And
in an important sense the two will always remain linked through their model.
Credit Suisse First Boston's Allen Wheat used derivatives
and charisma to become a leader in international investment banking.
Allen Wheat is a man in a hurry, though his genial style and broad sense of humor mask a driven personality. At 49, he is president and chief operating
officer of Credit Suisse First Boston. From an early job in the treasury
department of General Foods, Wheat's meteoric rise is a result of an early
appreciation of the power of derivatives.
Like all good bankers, Wheat ended up on Wall Street because of the money. "I'd been working at General Foods in the treasury department and I'd
done a few swaps when Bankers Trust offered me a job," he recalls.
"The money was great," And he was good at the swaps business.
Mind you, back in 1981, there was a lot of money on the table to be made:
"We got up-front fees of 50 basis points and spreads of 25 to 35 basis
points," he recalls.
But sitting still and coining it isn't the Wheat way. Eventually it occurred to him that Bankers Trust was missing a great opportunity by simply running
a matched swap book. "Of course it was a case of needing to do something,"
he recalls. "At some point, we found that we had plenty of people who
wanted one side of a swap but no takers on the other side." The transition
to banks as intermediaries changed the nature of the swaps business, and
Wheat says it wouldn't have happened without the support of Bankers Trust's
chairman at the time, Charlie Sanford. "He understood the need to hedge
these positions and how we could make money at it, which was rare among
top banking management at the time."
With that innovation, Wheat was well on his way to building a global
swaps business for Bankers Trust, one of the first single-profit-center
businesses on Wall Street. Meanwhile, Wheat, who traveled to Tokyo and London
for Bankers Trust, started developing a reputation as a financial whiz-kid
with an eye for picking talent to support him. As early as 1985, press reports
touted him as a charismatic leader who generated tremendous loyalty among
his staff. His Bankers Trust swaps team was known as the "Kool-Aid
Kids," in reference to the cultists who died after drinking a poison-laced
fruit punch at the behest of Rev. Jim Jones in Guyana.
In all, Wheat spent eight years at Bankers Trust, ending up as chairman
of Bankers Trust International in 1989. His grasp of the changing nature
of banking and global finance was instrumental in implementing the Sanford
vision of Bankers Trust as a corporate institutional bank. Wheat is also
credited with the decision to take the bank into the equity underwriting
arena in 1987, thereby breaking down a barrier between banks and Wall Street
With his track record and his knowledge of the derivatives markets and
what makes derivatives players tick, Wheat was destined to be on the wish
list of most of Wall Street firms. The firm that nabbed him in 1990 was
CS First Boston, which sent him to Asia to run its Pacific operations. It
was an important hire for the firm, which had begun what would become years
of reorganization and restructuring.
Organizationally, Wheat is best known for pulling together Credit Suisse First Boston's derivatives activities worldwide into an entity called Credit
Suisse Financial Products. At the time that Jack Hennessy, CS First Boston's
then-chairman, lured Wheat into his orbit, he said that the global swaps
and derivatives businesses had been the missing link needed to tie the group
together worldwide. It is ironic that CSFP proved a more successful global
organization than many of the numerous iterations of the Credit Suisse and
First Boston businesses.
For Wheat, the success of CSFP thrust him upward in an organization that is still reorganizing. Nowadays, far removed from "day-to-day deal
stuff," as Wheat would say, he nevertheless maintains a depth of knowledge
that has helped CSFP avoid some of the risk-management headaches encountered
by other firms. It's an important part of Wheat's view that Credit Suisse
First Boston needs to leverage its strengths, which, from where he sits,
is the ability for talented people to move beyond providing simple commodity
Risk management continues to be a high priority for Wheat and Credit
Suisse First Boston, but he says there has been a sea change in the ability
of senior management at banks and firms to understand how risk really works.
"Ten years ago, nobody senior had a clue," he recalls. "They
were completely ignorant. But that's all changed. Senior management understands
risk, systemic risk, all sorts of risk. They have put in place all sorts
of processes, computer reports that break it down to all levels. And liquidity
in the markets is much better. But there's always the possibility that the
rogue trader could lose a lot of money-that's always there."
Recently, he's noted another important trend: the decline of the highly
complex, highly geared transaction. "They just aren't being done anymore,"
he says. "The derivatives business is maturing. Products are standard,
generic. Margins are thin. It's beginning to look a lot more like foreign
exchange or government bond trading."
The challenge for firms like Credit Suisse First Boston is to think forward into the future about issues like staffing and organization. "We need
to find different ways of selling, integrating derivatives into the rest
of the business. We may need fewer rocket scientists. We'll always need
new products and innovative applications, but maybe we don't need an army
of people turning out highly geared, one-off transactions," says Wheat.
From where he sits, the impact of a maturing business is very clear.
Where the development of an equity derivatives business in the early 1990s
might have contributed $30 million-or a significant percentage thereof-to
he bottom line, he says, "today that is just a drop in the bucket."
The role of the derivatives operation will focus "less on structuring
securities and more on customizing transactions for an individual client."
Wheat is also a manager with an eye on costs, which has not always placed him in good standing with his employees. A brouhaha over pay erupted over
1995 bonuses and led, reportedly, to the departure of John Costas, co-head
of global fixed income at CSFB, who left for UBS, where he was recently
made head of global fixed income.
Looking to the future, Wheat says, costs will continue to play a part,
and back-office streamlining and a fully-functional global presence will
be key to success beyond 2000.
"There will only be a handful of banks with true global ability
and we will be one of them," Wheat says. When the millennium arrives,
Wheat will be only 52, making it likely that he'll be a force in the future
as well as the past of risk management.
The Arthur Andersen Hall of Fame Roundtable
Three Hall of Famers met for lunch on February 19 for a
remarkable roundtable discussion at New York's St. Regis Hotel. They recalled
the past, noted the present and contemplated the future of the derivatives
Richard Sandor, chairman and chief executive, Centre Financial
Myron Scholes, principal, Long Term Capital
Allen Wheat, president and chief operating officer, Credit Suisse First Boston
Joe Kolman, editor of Derivatives Strategy magazine
Michael Onak:, Americas director of Arthur Andersen's Derivatives and Treasury Risk Management consulting group and sponsor of the Derivatives
Hall of Fame Roundtable
Jitendtra Sharma, director, of Andersen's valuation and risk measurement group
Randy Marshall, director of Andersen's risk management practice
Michael Rulle, head, CIBC Wood-Gundy USA, and global head, CIBC
Wood-Gundy Financial Products
Joe Kolman: I'd like to start out by asking the honorees what
they imagined the derivatives business would be like when they first started
out. What unexpected turns did the derivatives industry take that surprised
them? Myron, what did you have in mind when you created your model? What
did you think your invention would lead to?
Myron Scholes: Well actually, we developed the model more out
of intellectual curiosity than actually trying build a product. We wanted
to understand how to price options because we realized that options were
embedded in many financial contracts. Outright trading and derivatives came
There wasn't much interest in derivatives until options started trading
on the exchanges. I was amazed at how quickly some of the Old Guard learned
to trade options using the Black-Scholes model to survive. They had been
writing some sort of over-the-counter options, but in most cases the strike
price was set equal to the underlying market price. And then they'd forget
about the option until it expired.
It was surprising how quickly old traders were displaced by those who
adopted a model, and understood the importance of delta and hedging. The
survivors quickly came to realize that to stay in the business, they would
have to learn how to price the options, not only at inception, but during
the life of the contract. No one had any experience. So to be able to have
sheets of paper that contained option prices for various market prices,
time to maturity, interest rates and strike prices was quite an advantage.
It was quite intriguing to watch all this happen.
I never really thought about the future of the derivatives business in
the right way. I thought about it from sort of a neoclassical perspective.
How do you price an option theoretically in a frictionless world? I could
have looked at the world, which has a lot of friction and certain costs,
and asked, "Is it more efficient to use a derivative than the underlying
instrument? And in what circumstances would it be used?"
If I had thought about that problem I might have realized that there
was a huge advantage to using derivatives in certain circumstances, and
not to rely exclusively on big coarse things such as stocks and bonds. The
other individuals here today did realize that using derivatives could be
a more efficient way of producing a product.
Allen Wheat: I had absolutely no idea that the OTC industry in
particular would become as large as it did. Absolutely none at all. I think
the reason I originally did it was that it looked interesting and seemed
more lucrative than what I was doing at the time. But never did I picture
that it was going to be anything near the size it turned out to be.
I came at it from the over-the-counter perspective. For me, the competition was the exchanges. What we did was either bigger, longer or less liquid
stuff. And then as the exchanges caught on, we were afraid they were going
to take our ideas and make them into contracts and trade them. But by then
we'd be onto the next thing. That's the way I saw the business originally.
Then it clicked: "Wait a second...you could act as principal! And rather
than being the enemy, you could hedge yourself on the exchanges." Then
the business took off. But I certainly never saw that at all when I first
When we first went to the marketing people and told them, "You'll
do all your deals with a book runner," a couple of them refused to
do it. They used to put together both sides of a deal by calling a potential
counterparty here and a potential counterparty there and try to match the
two. They'd say: "We are bespoke tailors, not sellers of off-the-rack
clothing." We had a rough time with them at first.
Scholes: The biggest thing was the transformation from the underwriter approach, which is matching the A person with the B person, to the principal
approach. And that was only possible with models. When one side of the contract
is in your own name, you have to figure out how to hedge those risks. Only
then could you cut the costs of trying to find A and B. And that allowed
you to offer a much larger set of products to clients, and more tailored
to what they need.
Richard Sandor: A lot of what happened in the exchanges volumes
was based on the work that Myron had done. Options and arbitrage theory
became the fundamental atoms of finance that brought about a marked change
in both the academic and practical worlds. Optionality was really the building
block for so much of the derivatives market. Once all the academic work
was done, we were able to introduce a wide range of financial exchange-traded
derivatives, including options, that speculators and hedgers of all sizes
In a larger context, all of us have been the beneficiaries of the establishment of the field of finance and the term structure of interest rates. In the
1960s, a financial economist had a very low standing with his peers. Finance
was where you sent people who couldn't do things out of economics departments.
Now we see very bright people becoming quantitative analysts and traders in derivatives departments. And the forecasting economist has taken a back
seat to the financial engineer. In fact, the academic world has turned out
an enormous amount of human capital, not only from finance and economics
departments, but also from math and physics departments. Very few of us
could have run our businesses without these types of people.
Michael Onak:: The increased use of quantitative techniques is
notable on both the dealer and end-user sides of the business. One way to
think about risk management is that it involves making informed choices
about risk positions. The information being used to make these choices is
better now than in the past.
Randy Marshall: One of the newest applications in risk measurement are the risk-adjusted-return-on-capital models. These techniques are increasingly
being applied not only at financial institutions but also in the commercial
and industrial sectors.
Scholes: But I get worried that people will seize on simulation
numbers or Value-at-Risk numbers or other approaches and be satisfied that
what they have is a sufficient statistic to understand the risk of their
portfolio. But that's only the start.
Onak:: Exactly. We face this challenge all the time with clients. Value-at-Risk and other methodologies are just tools, another reference
point, another source of information. These numbers don't make the decisions
for them. They still need to make a choice. Even when models are not particularly
robust, they can still be useful as long as the users understand what the
limitations are, and what those tools are providing and not providing-as
long as they don't think it's a panacea, and that they can rely on those
tools to the exclusion of sound business judgment.
Sandor: I think we're focusing a lot on the computer models and
systems. But as somebody who's managed a lot of traders, I see a human element
that is very, very critical. You can blame some of the recent major losses
on systems. But some of it you might have inferred from the behavior of
Jitendtra Sharma: Innovative financial products continue to develop. There are now at least 50 different ways to take risk, all using the same
amount of capital. As a result, there are now 50 different ways to use or
misuse capital. Some of the measurement methodologies, such as Value-at-Risk
or risk-adjusted return on capital systems, are another way to monitor the
deployment of capital.
Onak:: As complex as the derivatives business can be, many of
the control issues that have surfaced in the last couple of years have been
about basics. It's a detailed business, and it involves sticking to the
basics. You don't put someone in charge of both the front and back office.
You independently confirm all your deals. You balance your position daily.
You have independence between those who monitor risk and those who take
it. In many control failures, there was a violation of some basic internal
control principles that should have been performed daily.
Marshall: Over the last couple of years, some corporates have
gotten into trouble with exotic products. Dealers have taken some heat here
as well. Have you seen any difference in behavior either on the dealer or
end-user side in transacting exotics?
Wheat: I think a number of the corporations that got in big trouble were the ones that viewed the treasurer's department as a profit center
but were not adequately supervised to be one. And when that happens, these
guys started to take things that were leveraged, five, 10, 15 times, where
there could be no business justification for it. In short, pure speculation.
Management did not fully understand the transactions. Now the corporate
boards have gotten very involved, as well they should. And they have much
tighter parameters on what they can do.
Michael Rulle: Since all Hall of Fame members have confessed that they were not able to predict how the futures industry was going to develop
when they started the market, I'd like to give them another chance to predict
the future. The growth of the derivatives market has been correlated with
the growth of the securities markets. I don't know if one has been the cause
of the other, or if both of them are the result of something else. But not
all areas of financial markets, or, for that matter, commodities and real
estate, have become as liquid as the securities markets. In what other potential
markets, financial or otherwise, can we use derivatives to create greater
Sandor: If you want to look at cash markets that are $10 billion
to $5 trillion, you have to start looking at markets like electric power
or real estate, in which the transactions costs are very high. It is possible
that derivatives can provide some real value added to these markets.
I think you're seeing it already in REITS, insurance and environmental
areas. Innovative small markets are also possible because of the technology.
Look at the whole trend toward trading recyclables. It's on the Web. There
are 180 users trading recycled products such as glass and paper. We're trading
sulfur dioxide allowances. We're looking at water rights in the West. You
can put up hundreds of these things. Government-mandated regulated markets
can be replaced by a pricing system. And you can use low-cost technology
to distribute that price, and transfer ownership rapidly. It's already there.
One of the big drivers is deregulation. In the past, the government fixed the price of one side of the balance sheet, asset or liability, and the
other side was variable. This was the case with S&Ls, banks and insurance
companies. A similar situation awaiting complete deregulation is the electric
utility industry, which has variable input costs, but is subject to fixed
output prices determined by the government.
Scholes: I always felt that finance had certain standardized functions, and that the standardized functions of finance can be satisfied in many
ways. These functions include the raising of capital, the exchanges of assets
in markets, risk transfer and reduction, saving for the future, providing
valuation signals, and reducing frictions.
When I look at new instruments or new ways of doing things, I ask: Do
they satisfy these functions for investors and corporations in a more efficient
Derivatives present a more efficient way to do things than by doing it
directly, say by issuing securities. But others believe that's not the most
efficient way to do it. They might argue that we are fooling ourselves to
think derivatives are the most efficient way to do things for the long term,
because computers or Webs or whatever else might come along in the future
might be more efficient.
New instruments or procedures might be developed that will be more efficient than using derivatives. We might go back in the future to the underwriting
approach. Who knows, Jones and Smith might know much more through computing
devices. And it will become closer to a frictionless market. You won't have
a bank saying, "I'm going to offer you a derivative product to hedge-out
risks, or sell it or manage it."
Derivatives may be less costly than what we did in the past, but they
still are costly. So maybe Richard's world will come to that: We'll all
have virtual reality sets on our heads and be able to see everything instantaneously,
and we won't need any intermediaries anymore.
Sandor: That's an awful thought. (Laughter).
Scholes: It's a possibility. We left the world of the first best
when the apple was eaten. That's the frictionless world. It's where all
knowledge and everything is mutable. And now we're in the world of the second
best. Some might say third best. It's a place where you have to figure out
how to do things more efficiently. And that's how you make money, by innovating-reducing
the cost of providing those services.
So yes, corporations will use derivatives more and more if it is efficient to do so. Individuals will use derivatives in their investment programs
more and more if it is efficient to do so. We can't say that derivatives
will completely dominate other ways of achieving the same ends. But they
can certainly compete.
The Andersen Hall of Fame Roundtable is sponsored by the Derivatives
and Treasury Risk Management Consulting Group of Arthur Andersen.