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Turning The Exchange World Upside Down

Jorg Franke is not credited with developing scads of innovative financial products, earning billions of dollars using cutting-edge trading strategies, or adding to the intellectual or scientific foundation on which the derivatives industry rests. His contributions, arguably, are even bigger. More Bill Gates than Thomas Edison, Franke has revolutionized the way derivatives traders do their business.

Franke's goals earlier this decade were audacious and, to many, implausible: to expand the nascent German derivatives market dramatically by creating the Deutsche Terminborse, a fully electronic derivatives exchange that would compete on the world stage with the likes of the Chicago Board of Trade, the Chicago Mercantile Exchange and the London International Financial Futures and Options Exchange. Last year, electronic-trading naysayers were silenced when the newly formed Eurex Deutschland, a merger between the DTB and the Swiss Soffex, quickly leapfrogged the Merc and Liffe to become the second-biggest derivatives exchange in the world, after the CBOT. Eurex's startling ascent sent shock waves through an industry that had done things pretty much the same way for 150 years. No one has felt the reverberations more than the Liffe, which now finds itself teetering on the brink of irrelevance.

Franke wasn't always a revolutionary. After earning German law degrees in 1968 and 1969, he took a modest job in the legal department at Westdeutsche Landesbank. One day, the head of the legal department asked Franke to help a colleague with some questions concerning short sales and forward contracts in the United States. It was no simple assignment—no one in the bank had the foggiest notion what the legal consequences of U.S. short sales were. Franke surveyed the situation and decided to hit the books—American business textbooks, that is. He quickly became an expert on futures and options law and moved to the securities department at Landesbank, eventually taking charge of new equity issues.

At the time, the West German derivatives markets were fraught with problems. The option market began in 1970, but for years it was barely a market at all—traders could buy puts and calls, but regulations forced them to sit on the contracts until expiration. But as business boomed in Chicago, German financial institutions began to complain of illiquid and inefficient derivatives markets at home. A coterie of German banks got together in 1987 and decided to develop a single German derivatives exchange to centralize the country's scattered, thinly traded markets.

When the group of German banks came calling in late 1987 with a plan to set up a single German derivatives entity, Franke, now the general manager of the Berlin Stock Exchange, was all ears. He signed on in July 1988 as the CEO of the inchoate exchange, which at the time was known only as GMBH, a limited liability company. For a while, Franke was its only employee.

New paradigm

The problem, as the group of banks saw it, was how to link market members from Hamburg, Berlin, Stuttgart, Munich and Hanover together without forcing them to converge on a single trading floor. The answer, it seemed, was deceptively simple: build an all-electronic exchange, free of the encumbrances of open-outcry trading. There were two minor problems: a battle-tested model for such an exchange did not exist, and open outcry had been firmly entrenched as the exchange trading method of choice since the beginning of time.

But revolution was already in the air. The fledgling Soffex, which would become the world's first all-electronic derivatives exchange, had spent millions of dollars developing an electronic system that was scheduled to go on-line in 1988. GMBH decided to use Soffex's system in its entirety—quite a risky proposition for Franke, since the Swiss system was only in the implementation stage at the time.

Holed up in a single office rented from Commerzbank in Frankfurt, Franke rolled up his sleeves and went to work. In addition to the nuts-and-bolts tasks of starting an exchange—hiring staff, formulating operating strategies, setting up new rules and regulations, paying the electric bill—Franke was responsible for selling the electronic trading concept to German investors. He had the full support of the group of banks that had created the German derivatives market in the 1980s, as well as the Soffex management. At first, however, the reaction was mixed. German investors were generally wary of futures and options, and futures and options traded on an electronic exchange struck many conservative Germans as the height of insanity.

By late 1988, however, Soffex had launched successfully. There were no major technological glitches, and, by 1990, it enjoyed growing liquidity. Pointing to the success of Soffex, Franke and the supporting banks began to convince investors of the viability of the German exchange.

Plugging in

In January 1990, Franke and his cohorts flicked on live DTB trading screens for the first time. On the first day, 12,000 contracts were transacted across the thousands of miles of wire that connected the early market members. The DTB was launched with a mere 14 options contracts on German equities.

Eurex's startling ascent sent shock waves through an industry that had done things pretty much the same way for 150 years.

But by the end of 1990, the DTB raised the bar by listing futures contracts—including a futures contract on the German Bund. For the first few months, Bund trading volumes languished, hovering somewhere in the single digits and rising no higher than a 25 percent market share after five full years. Germans who had expected the Bund to revert to its home country were dismayed to see that Liffe, which had traded the Bund via open outcry for years, continued to hold the contract in a hammerlock.

Technologically, however, the DTB was a smashing success. In 1991, the DTB listed futures and options on the Dax, which would prove to be among the most popular derivative products in the world. In 1992 the exchange became the largest options exchange in Europe and the third-largest derivatives exchange overall. By 1995, after unveiling a slew of smaller products, the DTB had overtaken the French Matif to become the second-largest derivatives exchange in Europe.

Franke's biggest battles in those days were old-fashioned turf wars. Regulators in the United Kingdom, France, Switzerland, the United States and elsewhere were reluctant to allow DTB screens to be set up in their countries—a crucial step for the DTB in building a global business. “We asked the London HM Treasury to recognize the DTB as an overseas exchange, which would have allowed traders and members in London to be connected to DTB,” recalls Franke. “We didn't get it. Instead, we got a long list of questions. We answered those questions, and nothing happened. When we'd phone and ask about the recognition, they'd say, ‘Oh yes, it's fine that you answered those questions, but there are more questions, and we'd like to send them right now.' We'd wait two weeks, three weeks, a month. When we got them, we would answer them immediately, and still nothing happened. There were always more questions.”

Finally, in the beginning of 1995, a new European monetary union directive gave the DTB the right to place screens throughout Europe. Volumes at the DTB took off. By late 1997, the exchange had crept up to nearly 50 percent of the Bund contract. Liffe began getting nervous. In February 1998, the DTB announced the formation of Eurex Deutschland, a partnership between the DTB and Soffex, with promises to include more exchanges in the future. At the time, Franke was asked what his predictions were for 1998. He said he'd be happy with a 60 percent share of the Bund market. Perhaps he was being facetious. By June 1998, the DTB had captured nearly 100 percent.

Why did the Bund contract succeed so dramatically? “There are two reasons,” says Franke. “First, we got more and more market members trading directly from London. Now, 65 of our 315 member firms trade from there, and we have member firms in 16 countries worldwide, including the United States. There's no need to come to Frankfurt and set up a branch or subsidiary—members can trade from their desks, in their offices, in their bank. Second, trading the Bund contract on Eurex was far cheaper than at Liffe in terms of total cost. Firms that traded similar Bund volumes at Eurex and Liffe needed 60 people in London vs. only 10 for Eurex. People thought about this and changed, step by step, from open outcry to the electronic trading system.”

The result? Liffe announced last year that it planned to switch over to an all-electronic trading system by the end of this year. Locals at the CBOT, fearful of an all-electronic future, last December elected a new chairman who had railed against a proposed electronic linkup with Eurex. In January, CBOT members formally rejected the proposed alliance. The Merc, meanwhile, launched a new electronic trading system that is already handling intraday trades of mini equity index futures, and has struck an agreement with Matif to trade each other's products, much as the former CBOT regime had planned to do with Eurex.

The techological revolution Franke set in motion in 1990 has turned the world of derivatives exchanges upside down. Not bad for a lawyer from Westdeutsche Landesbank.


Innovator and Visionary

The fact that Lisa Polsky was among the first people to bring a computer to a trading floor—albeit a primitive Radio Shack TRS-80—would in itself warrant serious consideration for Hall of Fame induction, given the integral role computers have come to play in the business. But Polsky's contributions to the derivatives industry over the past two decades are far more sweeping. Indeed, virtually every point on her curriculum vitae's timeline represents the industry's cutting edge.

One of the great ironies of her career is that Polsky, a “super-quant” options trader, did not come to Wall Street with a freshly minted degree in physics or mathematics. She graduated from New York University in 1977 with a B.S. in international business and economics.

Mathematics, modeling and “just figuring things out” were in her blood. Her mother worked on the first ENIAC computer at the University of Pennsylvania in the 1940s, and her father was a professor of law and medicine at Temple University. “Instead of singing ‘Kum Baya' on the way to our beach house,” Polsky says, “my mother played math games with us—like calculating the distance, rate and time to get there.”

Polsky got her first job working at Predex Corp., a currency forecasting service. That led to work at General Electric in currency risk management and eventually, in 1980, to Citibank, where she developed an early model to help corporations time their hedging of currency exposures with forward contracts. She started using the model to trade spot foreign exchange, and quickly began racking up big returns. But Polsky was eager to go beyond trend models. Influenced by early work on currency options by Steve Kohlhagen and Mark Garman, she began talking about more flexible ways to hedge currencies.

Her first option client was Nestle, which in 1982 had a Swiss franc/dollar exposure it needed to hedge. Both Polsky and Nestle's financial managers had a strong view that the currency was moving in their favor, and therefore they didn't want to lock in rates with forward contracts.

Polsky suggested a revolutionary concept: an option contract that gave Nestle the right to buy Swiss francs in three months at a certain strike price, in exchange for the payment of a premium. Nestle loved the idea, but Polsky's boss was skeptical. “How do you hedge these things?” he asked. Polsky explained the concept of delta hedging, told him it was only a $5 million contract, and reiterated that it was merely a three-month exposure. He agreed to let her have a crack at it.

The rest, as they say, was history. After building a strong FX options business, she branched out over the course of the decade into metals options, non-dollar interest rate caps and swaptions, bond options, and equity derivatives. Polsky is quick to point out, however, that she did not do any of this alone. She had a talented team of people working for her, many of whom are now luminaries in their own right. “That's what made it so much fun,” she reminisces.

By 1990, Polsky says, there had been three primary areas of growth over the previous eight years: by asset class, by geography and via customization. “In a sense,” she says, “options were born because customers said, ‘Forward contracts are useful for hedging some exposures, but they don't work for my problems—such as contingent exposures or for hedging accounting exposures. Collars, participations, lookbacks, outperformance options, average-rate options—all of these variations came about because customers said, ‘I like this product, but...' That became the challenge: to solve the problem and do a deal. The brainstorming sessions—working together to solve the problem—took the business to a new level. And by 1990 it had come pretty far.”

At about the same time, Citibank's billion-dollar loan write-offs were sending its share price plummeting. This inspired Polsky to start thinking about applying derivatives to credit. A meeting with senior executives responsible for lending was disheartening. When she suggested using derivatives techniques to evaluate the probability of default, they scoffed, saying it would lead to mark-to-market nightmares. “They thought it that would be bad in the lending business,” she recalls, “and would lead to tremendous volatility in the stock price.”

Polsky, however, believed that the march toward mark-to-market was inevitable—and she was ready to apply financial engineering more broadly across other areas of finance. So she called her old friend Kohlhagen, who was at Bankers Trust at the time—as was her former boss at Citibank, Yves de Balmann. Kohlhagen introduced Polsky to Gene Shanks, the bank's president. “We got along great,” says Polsky. “I thought he was such a visionary, and incredibly strategic in his thinking. We had a great, wide-ranging conversation about the financial markets and where the business was going.”

“Collars, participations, lookbacks, outperformance options—all of these variations came about because customers said, ‘I like this product, but...'”

Apparently, Shanks was similarly impressed. He offered her a job running the bank's equity derivatives business. Polsky faced a difficult decision. “Even though it was a smaller business than the one I had been running at Citibank,” she says, “it was with the right firm. I was willing to take one step backward to get two steps forward. I wanted to build my career in an institution that thought the way I did. Ultimately I wanted to have a say in the strategy of the entire firm that I worked for. I thought I had that chance at Bankers Trust. They valued innovation and creativity, and my strengths lined up against the firm's comparative advantage, giving me the chance to make a strategic difference.”

Polsky joined BT in 1990 as head of its equity derivatives team. Soon, her duties were expanded to include fixed-income, foreign exchange and equity derivatives trading in the United States, Canada, Latin America and Europe. In 1991, one of her colleagues at BT, Peter Freund, invented credit derivatives. “I remember how excited I was when I heard him present the idea at the first derivatives off-site conference I attended at BT. I knew then that I had joined the right firm.”

In 1993, Shanks presented her with an offer she couldn't refuse: the chance to “reinvent” asset management. BT's asset management division was huge, and most of its funds lay in passive index funds. But Polsky had no experience managing assets. So why her? Shanks remembered a prediction she had made during her initial interview. He had told her he was concerned that the derivatives business was too one-sided, that dealers were essentially selling insurance to customers, and that the business had to develop a two-way flow in order to continue growing. Polsky pointed out that the business was poised to do just that.

“In the 1980s, when I traded foreign exchange, if interest rates went up, people would think in terms of purchasing-power parity and conclude that the currency was going down,” she explains. “But by 1990, rising interest rates had begun to attract capital inflow. With capital flows becoming dominant, I predicted we'd see investors starting to use derivatives to enhance their yield. And when that happened, we'd be buying options from investors who wanted to enhance yield, and selling them to the trade-flow world as insurance. That would develop a two-way flow.” In 1991, a year after making this prediction, investors overtook corporations as the biggest customer base at BT. And Shanks did not forget who made that prediction.

In her new role as asset manager, Polsky and her team developed a series of hedge funds and began looking for new ways to apply financial engineering to fund management. “This is still a huge untapped opportunity,” she says. “Our idea at the time was to combine alpha with all of the other risk components—equity index risk, foreign exchange risk and so on—to create new products that give investors what they want, such as principal-protected hedge funds or funds “quantoed” into foreign currency. There's a huge opportunity to apply financial engineering to asset management. Most fund managers still sell products, the way dealers did in the world before derivatives. Financial engineering will enable them to create the products that their customers want, by combining the pieces that they already have.”

In late 1995, when BT saw a significant shift in senior management that changed the goals of the firm, Polsky thought it was time to move on. In January 1996, she joined Morgan Stanley as a partner and chief derivatives strategist—a new position in the firm. “The first product I had to develop was my job,” she quips. Again, it was a case of taking on less responsibility in return for a chance to work at what she believed was the right firm with the right group of people. She eventually settled into the role of global risk manager for the equities division, beginning with market risk and expanding into credit risk, liquidity risk, operating risk, sales practices and other areas.

Apparently, she impressed the right people again. Last month, Polsky was named chief risk officer for the entire Morgan Stanley Dean Witter juggernaut, combining market and credit risk in another newly created position. If history serves as a guide, Polsky will build a crack team that will blaze a new trail for others in the industry to follow—and set standards of excellence for them to emulate.

“One of the things I treasure at Morgan Stanley is that we run our business as a partnership,” she says. “The fact that I've been asked to be the firm's risk manager is not just my success—it's the success of the entire equity division. I'm confident about the future because I know that I've joined the industry's finest team, and I'll do the best job I can in building our successes.”


Outspoken Academic

Merton Miller spends much of his time holed up in the cloistered halls of the University of Chicago's Graduate School of Business, quietly analyzing the world's economic problems. But when it comes to certain matters of public policy, he often feels compelled to shout his opinions from the rooftops.

The often polemical professor was awarded the 1990 Nobel Memorial Prize in Economic Sciences for a series of papers he coauthored on capital structure and dividend policy, which have since become indelible components of modern corporate finance theory. Miller has also written extensively on derivatives-related issues in both scholarly journals and the mainstream press, serving as a passionate defender of and spokesman for the Chicago futures exchanges and the industry as a whole.

After graduating from Harvard in 1944 with an A.B. in economics, Miller worked as an economist at the U.S. Treasury and the Federal Reserve before getting his doctorate in 1952 at The Johns Hopkins University. He quickly landed a teaching job at the Carnegie Institute of Technology (now Carnegie Mellon University), where he met Franco Modigliani, another future Nobel Laureate. The two had adjacent offices during the eight years Miller stayed at Carnegie Tech, and their frequent conversations extended far beyond neighborly chit-chat.

In 1958, they collaborated on “The Cost of Capital, Corporation Finance and the Theory of Investment,” the first of a series of papers that came to be known as the “M&M theorems,” which would form the bedrock for much subsequent corporate finance theory. The first M&M proposition—and the most fundamental, since the others are derived from it—is that the value of a firm, defined as the sum of the values of all the securities the firm has issued, is independent of how that value is divided between debt and equity securities. This seems counterintuitive at first, since debt is considered by many to be a cheaper source of capital than equity (8 percent for debt, vs. 15 percent or more for equity). Miller offers a homespun explanation for the apparent paradox. “The simplest way to understand this is a Yogi Berra story. It's after the ball game, and a pizza man comes to deliver the pizza to the players. He says, ‘Yogi, how do you want me to cut this pizza—in quarters?' Yogi says, ‘No, cut it into eight pieces. I'm feeling hungry tonight.' The firm is the pizza and the slices are the debt, equity and other securities the firm issues. You can slice it up a hundred different ways, but you're always going to go back to the same pizza.”

The second M&M proposition is that the expected rate of return on a leveraged share increases with leverage, but so does its risk. The market likes return but doesn't like risk. But because value is invariant, the two effects must offset each other. Leverage, therefore, won't increase the market value of the levered shares.

The third M&M proposition holds that a firm's decision about whether or not to undertake an investment depends entirely on the risk-and-return characteristics of the real assets acquired, not on how those assets are financed. In other words, you can't turn a sow's ear into a silk purse just by leveraging it.

Another M&M proposition asserts that the value of a firm is invariant to its dividend policy, given its investment policy. Miller says that, although this too seems counterintuitive, it boils down to a simple premise: taking money out of your left pocket and putting it into your right leaves you no better off. When asked incredulously if that's what won him a Nobel Prize, Miller quips, “Yes, but we proved it rigorously.”

The rigorous proof of the first M&M proposition was, in fact, an arbitrage argument of the kind immediately recognizable to those familiar with the Black-Scholes option paper (both of whom generously acknowledged their debt to the M&M theorems). Miller notes, moreover, that the Put-Call Parity theorem, which is central to options theory, is essentially the first M&M proposition in another guise.

In 1961, Miller moved from Carnegie Tech to the University of Chicago, joining forces with such heavy-hitters as Milton Friedman, Theodore Schultz and George Stigler to preach free-market solutions to economic problems. In the 1970s, the university began what would become a long-standing tradition of fielding a representative to the Chicago Board of Trade's board of directors. The baton eventually passed to Miller, who served from 1983–85. His tenure at the CBOT initiated him to the inner workings of the derivatives business—knowledge he has tapped repeatedly over the last 15 years. In October 1987, on the heels of the worst stock market crash since the Great Depression, there were rumblings in the financial community—and especially in the press and Congress—that the Chicago Mercantile Exchange's index futures were one of the main causes of the crash. Leo Melamed, then the chairman of the Merc, asked Miller to serve as chairman on the Merc's Committee of Inquiry into the crash, along with Myron Scholes and Jerry Hawke.

“The term ‘derivative' was intended to be one of opprobrium —as was Yankee Doodle when the British troops taunted the colonials.”

The Miller Committee concluded that the crash did not originate in Chicago and move to New York, as the financial press had been asserting. Panic had, in fact, been percolating in New York at the same time it showed up in Chicago, but was undetectable, Miller later wrote, because the New York Stock Exchange's rules on opening trades “permit—even encourage—specialists to delay the opening of trading when the overnight accumulation of orders for a particular stock is too far out of balance to allow market clearing at a price near the previous close.” In Chicago, by contrast, prices adjusted downward immediately. “This difference in opening procedures in the two markets undoubtedly contributed to the widespread (but misleading) impression at the time that the futures market in Chicago, if not actually dragging down stock prices in New York, was at least signaling to an already panicky public that heavy new selling pressure was on its way to the market in New York.”

Miller's role as public defender of the derivatives industry had begun.

In 1990, he joined the Merc as a public director, and from that perch he continued to discuss the injuries suffered by the derivatives industry at the hands of a growing gaggle of attackers. One media outlet to which he has contributed frequently has been the editorial page of the Wall Street Journal.

Chief among Miller's targets: the New York equities establishment. He argued in the early 1990s, in print and speeches, that the New York Stock Exchange—and members of its retail brokerage claque, such as Neuberger and Berman—had waged a vicious propaganda war against derivatives expressly to protect their own financial interests. “The Chicago end of the business was, at the time, a small land in terms of the investment in the brokerage industry,” he reflects now. “New York went after the stock index futures industry tooth and nail after the crash, blaming everything on it. It was an organized response by the New York Stock Exchange and its brokerage community to a cheaper product that was being put out by its competitors.”

Miller even blames New York for the term derivatives. “It was invented in New York to be disparaging about the Chicago people,” he asserts, “as if meant to say, ‘We are the real market; you are merely the derivatives. You're the mistletoe wound around the oak, sucking out our life's juices.' It was intended to be a term of opprobrium—as was Yankee Doodle when the British troops taunted the colonials. Like Yankee Doodle, the term caught on.” Miller acknowledges that the New York–Chicago battle has now eased, although he takes no personal credit for the derivatives industry's moral victory. “After a while, the big New York brokerage firms and investment banks realized there was a lot of money to be made, and one by one they got into the business. Derivatives have become a big part of their stock in trade.”

Another of Miller's pet issues has been the false notion that index arbitrage leads to higher volatility. “The evidence is very clear on that,” he asserts. “Volatility was highest in the 1930s, and there were none of what people call derivatives available then. There have been volatility spikes in every decade going back 125 years. The one thing we know about volatility is that when the market goes up, volatility goes down, and vice versa. It's not a result of derivatives.”

So has Miller mellowed of late? Certainly not toward the CFTC, which he continues to regard as a prime example of regulatory rent seeking. “The CFTC and its staff have glommed onto this industry like barnacles,” he snarls, “and there's no way we can seem to shake them off. Under the phony banner of customer protection—as if the exchange customers were still mostly Ma and Pa Kettles and not financial institutions—the commission serves only to create jobs for itself and to raise the costs of the exchanges relative to their OTC competitors.” For Merton Miller, the battle continues.

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