Hall of Fame 1998
How Edson Mitchell, Robert Merton, Conrad Voldstad and Derrick Tullet helped create the derivatives market—and turned the financial world upside down.
By Margaret Elliott
Although people know Edson Mitchell as a driven man, he is surprisingly and charmingly self-effacing. When talking about his achievements, for example, he attributes much of his success to the team of people with whom he has worked at Merrill Lynch and Deutsche Morgan Grenfell. But it is equally clear that the teams he has developed so carefully over the years have succeeded because they have adopted a common philosophy: Think creatively, work hard and above all, produce.
Mitchell, who heads global capital markets at DMG, was given the job because of his role in building Merrill into a capital markets powerhouse. His career predates the over-the-counter derivatives market by a few years. After an undergraduate education at Colby College in Maine and an MBA from the Amos Tuck school at Dartmouth, he began his career working as a commercial banker in Bank of America's Chicago branch. "Chicago was a big hub for corporate relationships across the Midwest,” says Mitchell. "So it was an excellent place to start out.
Several years later, Mitchell was recruited by Roger Vasey at Merrill Lynch, who was setting up the firm's money market operation. The theory behind Merrill's effort was broader than usual—moving beyond short-term instruments into the then-blossoming MTN market. For four or so years, Mitchell was happy in this rather innovative environment, calling on clients and structuring new products, including most notably interest rate swaps. "Vasey wanted Merrill to be a top-tier capital markets firm, but it wasn't,” he explains. "So he encouraged us to be creative. We did our first swaps with clients in 1983 or 1984. We certainly weren't leaders in the swaps market at the outset, nor a pioneer in terms of timing. But we tried to broaden the market.”
The key to Merrill's eventual leadership in the derivative markets was, as Mitchell puts it, "the linkages within the units. We integrated new issues, investor coverage, capital markets and derivatives.” Mitchell took over the syndicate and capital markets groups in 1985. But he knew, even then, that derivatives would be an important part of the mix. "It was our specific strategy to weave derivatives instruments into the capital markets as a way to catch up and overtake others in the market, such as Salomon Brothers, Morgan Stanley or Goldman Sachs, that were more established capital markets players,” says Mitchell.
To that end, Merrill hired Bill Brooksmit from Continental Illinois to run swaps in 1985. Mitchell took over the unit in 1986. "Until 1987, we focused exclusively on the U.S. dollar business, and we made inroads” says Mitchell. But then it was necessary to broaden the scope. So Mitchell hired fellow Derivatives Hall of Famer Conrad Voldstad, who at the time was fresh from international swaps in London. "We had Bill Brooksmit on U.S. dollar swaps and Connie Voldstad on non-dollar,” he explains. "From 1989 to 1994 we were among the most profitable swaps group in the world.” Although Merrill wasn't the biggest swaps player, Mitchell credits the group's performance to the quality of integration between capital markets and swaps, the firm's coverage of investors and its global links.
When asked whether managers running global capital markets units need to have strong derivatives experience, he laughs and coyly says, "Not necessarily.” Then he thinks a moment and laughs again, ticking off the backgrounds of his team at DMG: Bill Brooksmit, head of European fixed income and derivatives; Grant Kvalheim, head of debt capital markets; Saman Majd, head of global derivatives; Martin Loat, cohead of global markets, Asia; Pablo Calderini, head of the emerging markets group—all hail from derivatives groups at one firm or another. When Mitchell finally reaches his global head of sales, Anshu Jain, who has worked in derivatives marketing on both exchange-traded and OTC derivatives, he concedes the point. "I hadn't really thought of it that way, but I guess it is an important ingredient. Jain may be the first head of sales of a global capital markets firm to have an extensive derivatives background.”
When Mitchell moved to DMG in April 1995, he says he was almost as surprised as everybody else, but quickly got involved in the challenge of turning the bank into a first-tier global player. "I spent 15 years at Merrill Lynch and I never thought I'd leave,” he admits. "It was a phenomenal challenge. When I joined we weren't even in the top 15 derivatives firms globally. Now we're in the top five, and in some products we're number one or two. All the polls are showing that now. It is probably the biggest improvement in the shortest period of time, with the exception of Credit Suisse Financial Products.”
At Merrill, Mitchell was building a business from the ground up, with a young, enthusiastic staff and the full backing of a management group that could taste the future. Mitchell says the challenge at DMG is difficult. "The market standards we have to meet are very high,” he says. "The margins are thinner and there are more established firms out there ahead of us. I'm pleased with where we are now, but we certainly have a way to go.”
How does he plan to get there? "By playing to the strengths of the bank—the coverage in Europe, the credit rating, the access to clients,” he explains. "It's still the same ideas as it was at Merrill: using the derivatives thought process, employing smart people, focusing on relative value and integrating the group.
One deliberate choice that brought a bit of press fire was the decision to cut back proprietary trading to just 20 percent of revenue. "It's less than some of our competitors, but Deutsche has excellent client relationships. We need to use our capital to service clients first.”
But how do you produce above-average returns when there is so much human and economic capital using the same derivatives thought processes? "You have to stay out ahead in a few key areas, and you can't fall behind in any major area,” he says. "That means today moving aggressively into credit trading, securitization and high yield and concentrating less on plain vanilla instruments.”
Though Mitchell's grueling travel schedule—one week a month in New York, a base in London and extensive travel in Latin America and Asia—leaves him little time for extracurricular pursuits, he continues to maintain ties to his alma maters, sitting on the board of trustees of Colby College and the board of overseers at Tuck. He also maintains interest in environmental issues in Maine, where he grew up and still has property. And he finds time to track his five children, two of whom are in college.
Mitchell's stint at DMG has not been without controversy—press reports of outside salaries and internal divisions continue. But Mitchell is unfazed. "We don't pay over the market. We connect pay to performance. If someone is unable to produce, then they do not get compensated. It's very simple” he says. Happy to be navigating the ship, Mitchell will continue to do what he does best: creating a highly profitable, sustainable global markets business at Deutsche.
Back in the dark ages a dozen or so years ago, the young turks on derivatives desks spoke a language incomprehensible to senior managers at their institutions. Since then, a number of them have found their way into senior management roles. Connie Voldstad, a managing director and cohead of Merrill Lynch's global debt markets group, is an exemplary specimen of this new breed. A banker who knows global and knows derivatives, he's one of the new generation that grew up in the nascent swaps business of the early 1980s.
After studying math and history at Boston College, gaining an MBA from Dartmouth and adding a law degree from Fordham, he was recruited into the cultural immersion that was JP Morgan in the late 1970s. He found himself in London just as the swaps business was launched in the early 1980s. "We were leaders in the swaps market, which was terrific,” he recalls, "but we weren't organized properly.” JP Morgan had a global capital markets group and sold all kinds of products to its customers. For swaps, the bank was running a matched book (as was every institution at the time), so any swaps transaction required Morgan to find a counterparty. These were time-consuming deals. "Tony Mayer, then head of Morgan's capital markets group, realized we weren't focusing on swaps enough to maintain our market-leading position,” says Voldstad. "So he formed a dedicated swaps group.”
When Voldstad stuck up his hand and volunteered for the first dedicated swaps team at Morgan, or any other bank, "it was a bit of risk,” he admits. But his strong quantitative background and desire to develop a new business made him sure that this was the right move. The decision was helped by JP Morgan's unrivaled coverage of large institutions around the world.
The hallmark of the Voldstad approach to the swaps business was simple: never lose sight of the relationship to the underlying debt markets. At the time, this was a bit of an instinctual thing, but as the swaps market developed, the importance of this relationship came to be proven both in theory and practice. Critically, Voldstad's base in London made him acutely aware of the potential global nature of the business and the particular applications of swaps to cross-border and cross-currency deals.
A somewhat self-effacing man, Voldstad is quick to underscore the collaborative nature of his work at JP Morgan. In 1984, he was put in charge of the newly created global swaps group, though he remains reluctant to take sole credit for the group's phenomenal success. "We couldn't have done it without the groups in New York and Tokyo. Particularly in Japan—they were a huge source of private placement funding for swaps issuers initially,” says Voldstad.
A natural game player and puzzle solver, Voldstad eschews the notion that he had any foresight in getting into swaps. "I didn't know at the outset how quantitative the swaps business would become.” But wryly, for a lawyer, he admits, "I'm much more of a numbers guy than a lawyer.”
From 1984 to 1987, Voldstad continued to take more responsibility in London for JP Morgan. "I was always involved with products that had the same sort of approach—swaps, then options, then the concept of managing risk on a portfolio basis,” he explains. "It was a fascinating and energetic time. We developed a way of valuing swaps using more than zero-coupon yield curves. I guess you could call it applying defeasance technology to swaps.”
This was also the era in which the now-familiar concept of risk management on a portfolio basis—if not yet on a firm-wide basis—came to the fore. "No one showed us how. We had to teach ourselves risk management,” says Voldstad.
After sevral years as executive director for worldwide swaps and eurobond underwriting, Voldstad was eventually called home to the head office in New York as a senior vice president with the mandate to develop cross-market trading. While the move was terrific for him professionally, it did not involve clients, and the commute to and from Connecticut after years in Chelsea, London, didn't make the Voldstads happy. So he jumped at the chance to return to London with Merrill Lynch.
This move provided a new set challenges, one of which became the impetus for one of the most innovative new institutional structures yet seen in the derivatives markets—the triple-A swap subsidiary. In May 1988, Voldstad returned to Europe to head Merrill's nondollar derivatives business.
From 1988 to 1990, he had to confront head-on the fact that while JP Morgan had a triple-A rating, Merrill's was only single-A. Some counterparties simply refused to deal with Merrill. "It was impeding the growth of the business,” he notes bluntly. "We were losing business because of the rating.”
|The hallmark of the Voldstad approach to the swaps business was simple: never lose sight of the relationship to the underlying debt markets. As the swaps market developed, the importance of this relationship came to be proven both in theory and practice.
In 1990, it occurred to Voldstad and his team that it might be possible to synthetically create a triple-A balance sheet, much in the same way that securitization transactions used overcollateralization to provide a triple-A tranche. Once the idea for what became Merrill Lynch Derivatives Products, Merrill's triple-A swap subsidiary, was down on paper, Flavio Bartmann, who works with Voldstad, started working with Moody's to find out what it would take to get the rating agency to stamp a triple-A.
"We did the initial work with Moody's in London. MLDP was immensely overcollateralized, three to four times over. For example, its preferred stock was rated triple-A. I don't think there is any other company with triple-A rated preferred. We wanted to make sure that the capital was available to cure any defects, without question,” says Voldstad. Moody's spent six months working with Merrill. Voldstad calls the process "iterative. We both learned from each other.”
It wasn't an immediate hit in the marketplace. "We knew over time that it would work, but we did have to market the concept. We had to explain the mechanics, the independence of MLDP, the independent reporting,” he explains. Of course, Voldstad's persistence paid off. Today MLDP has more than $200 billion in notional swaps and 300 clients, including other banks that rent capacity on the swap subsidiary's balance sheet.
Today, Voldstad has again been recalled to the head office, after years in charge of debt markets for Merrill Lynch International in which he ran all government bond trading for Europe, capital markets origination, derivatives and eurobond activity. Now as cohead of global debt markets alongside Seth Waugh, the world is Voldstad's oyster. But it meant returning to the United States. Now he commutes from New Jersey to Merrill's Hudson Riverfront headquarters and misses London, but doesn't need to move back. "The challenges are here today,” he says.
As far as the future is concerned, Voldstad thinks that the high growth in interest rate and currency derivatives is behind us. "All the math has been done. The risks are understood. There's nothing radical in interest rate or currency derivatives,” he says. The growth in the future, not surprisingly, will be in credit and equity derivatives, and of course other types of derivatives in which "there is more talk than transactions,” such as weather, real estate and insurance.
"What we can do now is take out anything that people feel they'd rather not have. And by removing the risk, we also lower the cost of capital for most companies. That means a higher multiple in the stock market. It's an equation companies are beginning to understand better. It will open up the derivatives business in the next few years,” says Voldstad. Other avenues that the firm will pursue include products designed specifically for the investor side, such as structured notes and other liability-driven structures.
It's a long way from the trading desk and working out the math on a specific transaction. Voldstad misses the rough-and-tumble side of the business, but makes it down to the floor every day and still gets involved in tricky transactions. "But I can make a bigger impact through 2,000 people than I could as a single trader,” says Voldstad. "I get a tremendous kick out of seeing the younger people coming up through the ranks.” Voldstad may be an original thinker, but at heart he's a company man.
master of theory and practice
Nobel laureate Robert Merton considers himself the luckiest man alive. Not only has he been privileged to work with Fischer Black and fellow Nobel laureate Myron Scholes (1997), towering figures in the history of derivatives, but he studied under two other Nobel winners—Franco Modigliani (1985) and Paul Samuelson (1970)—and taught with another, Robert Solow (1987). And if all this intellectual stimulation weren't enough, he's had the remarkable good fortune to implement many of his theoretical ideas in the real world —from setting up the first mutual fund using stock options to his current involvement with the proprietary trading firm Long Term Capital Management.
Hearing Merton describe his life in relentlessly upbeat terms could send cynics to look for the downside. But surprisingly, there isn't one. Both his academic and real world lives segment neatly into three stages. In stage one, the young mathematical engineer discovered economics; MIT; and Scholes, Black and Samuelson. Trading warrants to supplement the pitiful income of an assistant professor fed the preoccupations of colleagues Scholes and Black, and, voila, options theory was born. In stage two, Merton and Scholes worked to apply options theory in the real world. And in the third stage, thanks to a long contract with Salomon Brothers, Merton became preoccupied with the idea of firm-wide risk management.
Merton's career is rare for an academic, particularly an economics professorand not just because he has won the Nobel prize. It is exceedingly rare for an academic to have a paralleland lucrativelife in the real world. "Most academic economists have little time for anything but the theoretical. Myron and I were lucky to have the opportunity to try out our theories almost immediately without giving up our day jobs,” says Merton. "In the last 30 years, the cutting edge for both theoretical and empirical research has been the same. That's not the norm, and it won't continue to be the norm.”
While the road from mathematics to economics today is well-traveled, when Robert Merton wished to switch Ph.D. subjects in the late 1960s, few institutions would have him. MIT offered him a fellowship. It was at MIT, too, that he received his first teaching job, thanks to Modigliani, in the Sloan School of Management, where met Myron Scholes, a newly minted assistant professor of economics. Both young turks were interested in warrants and instruments with nonlinear payoffs. Though Scholes and Black are most prominently associated with options theory because the seminal equation bears their names, Merton's insights and the paper he published the same year (1973) are an integral part of what is today known collectively as options theory. Indeed, Scholes in his Nobel prize acceptance speech in Stockholm referred most often to the collective work of Black, Scholes and Merton. But Merton says, "I take credit for Black-Scholes because I named it. They were reluctant to take the credit themselves.”
The collaborative effort started in the spring of 1970, when Black and Scholes showed their work on the capital asset pricing model (CAPM) and options pricing to Merton. At this point, Merton was a skeptic. He had worked out a theory of his own, the intertemporal capital asset model, which added the element of "continuous time analysis” to the then-static CAPM. When Merton looked at the math involved in Black-Scholes, he dismissed it as wrong. Then one Saturday afternoon, he phoned Scholes to admit that Scholes had been right after all. The Black-Scholes model did work, although Merton contributed a slightly more elegant mathematical formulation. When the first papers appeared in 1973, Black and Scholes had concentrated on a narrower use of options theory than Merton, whose paper, "The Theory of Rational Option Pricing,” covered the broader application of the valuation of the corporation.
Although young assistant professors weren't allowed much time off to pursue consulting projects or personal business in those days, Merton and Scholes managed to find time to help set up the options desk at Donaldson Lufkin & Jenrette before the opening of the Chicago Board Options Exchange in 1973. "Mike Gladstein contacted us after reading the papers,” says Merton. "We were a bit out of place. No one on Wall Street knew anything about partial differential equations at that time.”
Scholes and Merton's symbiotic relationship with Wall Street continued when the duo sought to launch the first mutual fund to use options to implement its core investment strategy. Merton and Scholes conceived of the fund during the 1974 bear market. They thought the fund would get hung up in red tape in the Securities and Exchange Commission for being too speculative, but it sailed though the vetting process. Unfortunately, when they launched in 1976, no one wanted a conservative strategy with a 95 percent principal loss floor, because the stock market was booming. It was a lesson in timing.
The next step for Merton, both intellectually and practically, was to look at the broader financial system, rather than simply at a single instrument. As a professor at a business school, rather than in a straight economics department, it isn't surprising that Merton became preoccupied in the late 1970s and 1980s with the issue of how to manage and run a financial institution. "I was privileged to be a consultant to the office of the chairman at Salomon Brothers when John Gutfruend was there,” says Merton. "I was completely free, because I had a day job. I was an inside outsider, able to see all the thinking. It was an enormous learning experience. But if I hadn't been a researcher, I wouldn't have been able to recognize and analyze the trends I was seeing. So both partsthe practical and the theoreticalhelped each other.”
It was a period of enormous change on Wall StreetMerton calls it a revolution of sortswhen firms began looking at themselves in a fundamentally different way. Technology played a major role in this transformation, as did theory when it came to figuring out the best way to manage the ungainly operations that trading firms had become.
Salomon Brothers introduced Merton and later Scholes to the group of traders that were later to become their colleagues at Long Term Capital Management, the four-year-old proprietary trading firm in Greenwich, Conn. LTCM is "the firm that was built based on the theoretical ideas we thought important” he says. "I'm the only partner not on site, but I'm connected via all the latest technology.” And for Bob Merton that's the way it should beone foot in academia and one foot in the financial world.
Expanding Interdealer Brokerage
In popular lore dating back to Mary Poppins and before, the city of London is full of gray-suited, bowler-hatted men with appendages at the beginning and the end of their names.
Nowadays, of course, few London institutions are owned by Brits, and last year, Derrick Tullet, the son of a city fruiterer, was given the title of Commander of the British Empire (CBE) in the last New Year's honors list for his service to British finance by Queen Elizabeth II.
Tullet founded Tullet & Tokyo Forex, a huge, increasingly global broker in the wholesale financial markets. Although not a household name, Tullet & Tokyo is a powerhouse, filled with energetic young traders gleefully competing to snare one of the legendary pay packets up for grabs in the foreign exchange business.
After an early start as a £500-a-year junior at ANZ Bank in 1955, Tullet soon joined a small foreign exchange broker, Savage & Heath, as employee number six, after the four partners and a son of one of the partners. "It meant I did a lot of work,” he says wryly, "but it was a learning experience.”
After rising to managing director in the 1960s, he left and formed Tullet & Riley with David Riley in 1970. It was the perfect time to start a new kind of foreign exchange broker, one that challenged the existing system. "It was clear that the world was changing in the 1960s,” he recalls. "Volatility increased, but I couldn't have predicted the effects of the sterling crisis and the collapse of Bretton Woods on the currency markets.”
Through most of the 1970s, Tullet & Riley remained a relatively small company with a tightly knit group of partner/traders who specialized in spot, forward and deposit currency trading. But it had higher ambitions. Tullet had worked for a year in New York in 1969—a market he describes as difficult for foreigners to break into. "British brokers always sought partners in New York and Chicago, but we made the decision to set up on our own, under our own name. It was a bit of a waiting game to get the necessary permissions and to build up a client base. But it was absolutely the right decision,” says Tullet.
In 1983, partner Riley retired and Tullet went looking for a new partner—this time a company that would be able to bring both capital and expertise to the enterprise. He found it in a somewhat unlikely venue—Tokyo. A little-known Japanese foreign exchange company called Tokyo Forex Co. became the joint owner of a new company, Tullet & Tokyo. In true Japanese fashion, the intricacies of the shareholding between Tullet & Tokyo and Tokyo Forex (not to mention other Japanese affiliates of Tokyo Forex) are labyrinthine. Yet the partnership has flourished where many other western relationships with Japanese firms have foundered. Tullet attributes the success to his deep friendship with and respect for Tokyo Forex head Koichi Yanagita.
A wholesale markets broker, a phrase Tullet prefers to interdealer broker, provides a "smart” independent price. Because Tullet & Tokyo runs no book of its own, it doesn't front run. As a result of this neutral position in the marketplace, it encourages dealers to use members of the Wholesale Markets Brokers Association.
|"It was clear that the world was changing in the 1960s. I couldn't have predicted the effects of the sterling crisis and the collapse of Bretton Woods on the currency markets.”
From its start with simple spot and forward foreign exchange and deposits, Tullet & Tokyo quickly expanded its product range to include a number of currency derivatives and trading products available today. As the products become more complex, Tullet sees the demand for higher academic standards for broking employees. "This requirement has risen dramatically in the last 10 years. A broker today needs to structure transactions and understand them, and that takes a high level of mathematics.”
During the late 1980s and early 1990s, all wholesale brokers faced the challenges of electronic exchanges, a knotty problem for companies built as voice businesses. "I don't think the need to have someone you know and trust on the other end of the phone will disappear, but we can't ignore the rise of electronic exchanges. I think many brokers in London have hoped that the issue will just go away, and [they] have lost ground because of that,” says Tullet.
"Electronic exchanges draw liquidity out of the marketplace when they first appear, and that is to no one's advantage. LIFFE now I think has it right, after a troubled start. I think an equilibrium will eventually be reached where electronic exchanges are used to transact a certain sort of commodity business, but there will also be a need for a voice service as a backup. Or customers may prefer to use the electronics to check prices on screen but transact on voice,” Tullet says. He applauds the current project underway among London brokers to develop a state-of-the-art electronic confirmation system that responds within two minutes. "We need it to stay competitive,” he says.
The foreign exchange challenge of the moment in Europe is the coming of monetary union. Tullet says the firm has already written out a plan that will change the configuration of its trading floor, though it isn't finalized. "I see four new blocks: euro, sterling, yen and dollar. And there will be huge interplay among these. But I also see people seeking new cross rates, with eastern Europe, emerging markets and Latin America. India and China are the next foreign exchange frontiers,” he predicts. To cope, Tullet & Tokyo recently bought a 20 percent stake in a firm in Argentina, bought 26 percent of a firm in India and has set up in eastern Europe. As a matter of policy, Tullet & Tokyo prefers to enter new markets under its own name. "We like to own the company,” Tullet says. "But in the case of Latin America and some other emerging markets, it is more prudent to dip a toe in first.”
When asked about the future, Tullet says, "We can see about three years out, but five years, we have no idea. Telecommunications and electronic links are changing the business as fast as anyone could conceive. But we are the ultimate service business, so we have to keep up.” A trim man who still plays competitive squash, there's no doubt that Tullet has the energy to keep lapping the competition.