Reform of the OTC Derivative Market
Henry C.K. Liu
Part I: The Folly of Deregulation

This article appeared in AToL on December 3, 2009

On October 7, 2009, the United States House of Representatives Committee on Financial Services at long last held a public hearing on Reform of the Over-the-Counter (OTC) Derivative Market: Limiting Risk and Ensuring Fairness.
OTC derivatives are contracts executed outside of the regulated exchange environment whose values depend on (or derive from) the values of underlying assets, reference rates or indexes. Market participants use these instruments to perform a wide variety of useful risk management functions. The Bank of International Settlement (BIS) reports that the notional value of all outstanding OTC derivative contracts ending June 2009 was $49.2 trillion worldwide against a 2009 world GDP of $65.6 trillion.
In the US, congressional hearings are the principal formal venue by which committees collect and analyze information in the early stages of legislative policymaking. The House Committee on Financial Services oversees and formulates policies and develops legislation that govern the entire US financial services industry, including the securities, insurance, banking, and housing industries. The Committee also oversees the work of the Federal Reserve, the central bank, the Department of the Treasury, the Securities and Exchange Commission, and other financial services regulators and agencies. As such, its mandate covers the OTC derivative market where derivative instruments are traded directly between counterparties outside of exchanges. The largely unregulated OTC derivative market has been a major source of systemic risk in financial markets. The Committee is currently chaired by Representative Barney Frank, Democrat from Massachusetts, with Republican Spencer Bachus from Alabama as ranking member.
Witnesses initially called by the Committee for the hearing were all derivative industry representatives. The list included Jon Hixson, Director of Federal Government Relations at Cargill, an international provider of food, agricultural, and risk management products and services that relies heavily upon futures and OTC markets. Cargill is an extensive end-user of derivative products on both regulated exchanges and in the OTC markets. It also actively offers risk management products and services to commercial customers and producers in the agriculture and energy markets. On the list was also James Hill of Morgan Stanley, appearing on behalf of the Securities Industry and Financial Markets Association, Stuart Kaswell of the Managed Funds Association which, through one of its lobbyists, has delivered significant “bundled” donations to Congressman Frank. Another witness was Christopher Ferreri of the Wholesale Markets Brokers Association. All are or represent beneficiaries of deregulated derivative markets.
Robert A. Johnson, Director of Financial Reform at the Roosevelt Institute, was added as a witness at the last minute after protests made to Chairman Frank by Americans for Financial Reform, an organization of some 200 citizen groups advocating the interests of consumers, labor unions and small businesses. Johnson prepared an opening statement which focused, among other concerns, on the “structurally dysfunctional money politics system” that allows legislators to be improperly influenced by well-financed industry lobbyists and campaign contributions. Johnson’s point was validated by the fact that his opening statement was cut short by Congresswoman Melissa Bean, Democrat from Illinois, who chaired the meeting in the absence of Chairman Frank and whom Harpers Magazine described as “another industry-funded committee member”. Johnson’s written statement was kept off the committee’s website on a manufactured technicality, presumably to suppress awkward public exposure of Wall Street financial support to Democratic legislators. 
The draft of the reform bill fails to call for the establishment of a special exchange for OTC derivatives as proposed by some reformers. It proposes instead to establish a clearinghouse, which is a weaker vehicle for tracking OTC derivative transactions. But it also would allow banks and their counterparties to be exempted from posting such transactions to the clearinghouse if the parties do not wish to, by simply claiming that their derivative contracts do not fit into standardized formats enough to benefit from centralized clearinghouse practices. An earlier draft of the bill would even have exempted transactions designed to hedge risk. Since practically all speculative derivative contracts contain elements of risk hedging, it would mean that essentially all derivative contracts could be exempted.
In an interview with Democracy Now, Johnson characterizes the reform bill as “too tepid, too weak, too late … Very industry influenced. We had a crisis and they are pandering to the perpetrators.”
All may not be lost. The legislation also has to pass the House Agriculture Committee, chaired by Congressman Collin C. Peterson, Democrat from Minnesota, which is more likely to include a requirement that derivative contracts be traded on an exchange, or at least that banks and companies report their derivative contracts to a clearinghouse. “As things stand now, I’d be more inclined to support the Ag bill,” says Chairman Frank of the House Committee on Financial Services. Robert Johnson, allowed to testify before Senate Agricultural Committee, reveals 4 major flaws in the financial sector.
Reform towards Deregulation
Finance deregulation took a great leap forward with securities litigation reform after the Republicans captured the House of Representatives in November 1994 in President Clinton’s first mid-term election which lost control of Congress to the Republicans. The Private Security Litigation Reform Act of 1995 (PSLRA) was passed easily by a Republican controlled Congress and, with Democrat support, even overrode a perfunctory presidential veto. The law was signed into law by a deeply wounded Democrat president who desperately needed Wall Street financial support to win a second term. It is a testimony of Clinton’s political ingenuity that the orchestrated bipartisan veto allowed him also to avoid losing campaign donations from trial lawyers.
PSLRA was ostentatiously directed at aggressive security litigators, the most successful of whom was Bill Lerache, who had recovered billions for shareholders victimized by security fraud committed by management. Lerache and other partners in Milberg Weiss later pleaded guilty to making “false material declarations under oath” in federal court proceedings, allegedly intended to conceal $11.3 million in secret payments and kickbacks that the firm was said to have paid to named plaintiffs in more than 225 class actions suit in order to secure the standing to file the class action suits. Still, the suits that Lerache successfully brought were themselves of undisputable legal merit.
PSLRA made security fraud cases more difficult for plaintiffs to win. It reflected the belief prevalent among those in charge of the financial system that the market is the best self-regulating mechanism against fraud and abuse out of self interest without the need for added legal constraints. Alan Greenspan, former chairman of the Federal Reserve, Robert Rubin, former Secretary of the Treasury, and Arthur Levitt, former Chairman of the Security Exchange Commission, all were strong believers of the myth of market self-regulation and used their considerable influence to help create a deregulated regime in structured finance.
Skeptics of Self Regulation
There were skeptics of market self-regulation. James S Chanos, head of Kynikos Associates, a short-selling hedge fund with $3 billion under management, was known for being the first to question Enron on its accounting fraud and for tipping Fortune
magazine reporter Bethany McLean on it, testified before the House Committee on Energy and Commerce on February 6, 2002 that PSLRA was responsible for the dramatic increase of fraud from 1995 through 2001 and that the statute “has emboldened dishonest managements to lie with impunity by relieving them of concern that those to whom they lie will have legal recourse. The Statute also seems to shield underwriters and accountants from [legal accountability for] lax performance.” He added that “no major financial fraud in the United States in the last ten years was uncovered by an outside accounting firm.”
Derivative Market propelled by Financial Innovation
Financial innovation propelled the development of derivative market which in turn became a fertile field for abuses that caused serial financial crises around the world since 1994, starting with the Mexico peso crisis, the collapse of 233-year-old British firm Barings inn 1995 from the billion dollar loss incurred by derivative trader Nick Leeson, the 1997 Asian financial crisis detonated by the Thai central bank’s inability to sustain the fixed exchange rate of the overvalued baht, and the 1998 financial crises in Russia and Brazil that froze global markets briefly and subsequently cause interconnected markets to crash in locked steps.  While each of these crises had its own particular roots, the vehicle that caused market failure in all cases was derivative trading.
Difference between Exchange-traded derivative and OTC derivatives
Derivatives tighten the connectivity between markets and enhance market efficiency. But they do this by increasing systemic risk globally if left unregulated. Exchange traded derivative contracts are generally standardized and investors are protected against fraud and default by transparency and the financial reserves of the exchange. OTC derivative contracts are uniquely structured and traded directly between contracting parties with full assumption of risk of counterparty default. Many large financial institutions, including big banks, generate handsome fee by acting as a private clearing houses for OTC derivative contracts. However, OTC derivatives traded by large financial institutions that also trade with other large financial institutions present systemic risk to the whole interconnected market.
The Myth of Self Regulation
Yet many policymakers and legislators still do not have a clear understanding of the nature of financial derivatives or how the derivative market actually works. While the destructive potentials of financial derivatives have been recognized since their invention thirty-six years ago, most regulators still lack the full understanding needed to design effective regulation for the derivative market, particularly the OTC derivative market. As a result, they tend to accept the myth of self regulation as the best, albeit still imperfect, solution propagated by influential free market ideologues.
This is because the innovation-driven workings of the OTC derivative market are constantly evolving out of the public eye, making it difficult for anyone who is not a direct market participant in bilateral counterparty contracts to develop effective regulation to protect the financial system from derivative-induced systemic meltdown and to protect the general public from risks of loss. Yet, bilateral derivative contracts are hedged through interconnection throughout the entire market. These contracts manage unit risk by transferring it to systemic risk. Thus regulation needs to be focused not just on size, but also on the location of strategically placed fire breaks to prevent systemic contagion. Such systemic contagion can travel without even a direct physical connection. During the 1997 Asian financial crisis, speculators sold in strong but highly liquid market in futile attempts to save distressed position in illiquid markets, bringing the entire global market down.
Individually Benign yet Systemically Dangerous 
Derivatives, financial instruments whose values are derived from underlying assets, are not by themselves toxic financial products invented by evil financial wizards. They are rational instruments for unlocking latent value in financial transactions through mathematical logic. With precise measurement of derived value and immaculate logic in risk management, full potential net value can be effectively captured for both the participating parties and the economy as a whole that otherwise would be left untapped in conventional financial transactions. By definition, value creation is a positive contribution, but only net value creation after taking into account risk of loss can be a positive economic contribution. Creating or capturing value via unknown risk is merely gambling with luck. Derivatives, by their opaque nature, only hide risk by dispersing it, but not by extinguishing it, allowing the risk to stay invisibly in the system, thus creating a false sense of safety. Such instrument structurally under-price risk by only hiding it. (Please see my May 23, 2002 article: The Danger of Derivatives)
Synthetic Notional Value
A derivative, being a financial instrument that derives its value from an underlying asset, is a sophisticated vehicle for pricing derived values that are affected by market risks. Rather than trading or exchanging the underlying asset itself, derivative traders enter into contractual agreements to exchange cash flow, or assets of equivalent value, over time based on expected future value of the underlying assets. A futures contract is an agreement to exchange the value of an assumed underlying asset at a future date, but not necessarily the physical asset itself. Thus was born the concept of notional value in derivative structures.
The Use of Leverage
To capture minute change in value, derivatives are routinely structured with high leverage so that a small movement in the value of the underlying asset can cause large changes in the value of the derivative contract. This leverage, coupled with the astronomical growth of the OTC derivative market, has turned many financial institutions that participate in this market into “too big to fail” entities, the failure of which can cause serious systemic impact, allowing them to expect government bailout by holding the financial system hostage in a distressed market to prevent systemic collapse. Thus the “too-big-to-fail” syndrome leads directly to heightened moral hazard. Still, leverage is the music of the derivative market. Without access to leverage, the derivative market will have no dancers.
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1. After the rule was exempted in 2004 for five big firms, many hedge funds increased their leverage to 40-to-1 to maximize profit by enlarging the risk profile by trading with the big five. (Please see my January 22, 2009 AToL article: The Zero Interest Rate Trap)
Moral Hazard and Too-Big-to-Fail
Moral hazard generated by the “too-big-to-fail” syndrome distorts the risk management role of derivative structures. It turns the hedging function of derivative into profit centers derived from an under-pricing of risk for unsustainable gains.
The solution to the “too-big-to-fail” dilemma intuitively lies in preventing institutions from getting too big. Yet because of interconnection of markets, even failure of small entities in large numbers can trigger systemic failure. This gives even larger numbers of small entities of similar risk profile, but each not too big to fail individually, the ability to cause systemic failure.

In mathematics, the theory of large numbers includes the phenomenon of unsustainable exponential growth which occurs when the growth rate of a mathematical function is exponentially proportional to the function’s escalating value. Such exponential growth is mathematically unsustainable and will eventually implode. Malthusian population theory is based on the un-sustainability of exponential growth.

Multilevel marketing is designed to create a fast growing marketing taskforce by compensating not only for sales it generates, but also for the sales of other new marketing taskforces introduced to the company by each existing marketing taskforce, creating a limitless down-line of distributors and a hierarchy of multiple levels of compensation in the form of a pyramid, such as that employed by Amway Corporation. The crisis in sub-prime mortgage is caused by massive network marketing, even as each subprime mortgage individually is only a small contract.

No bank, however big and well capitalized, can withstand the onslaught of a systemic breakdown of market-wide counterparty exposure built by multilevel marketing of liabilities such as subprime mortgages and their securitization.

The Need for Firebreaks

Thus the problem of systemic market failure is caused not merely by unit bigness, but also by the absence of firebreaks to prevent exponential growth and the resultant systemic contagion effect of large number failures from chained counterparty reaction. It is hard to understand why policymakers are not cognizant of this obvious fact enough to focus on the need for firebreaks in interconnected financial markets to both prevent the buildup of risk chain reaction and to contain systemic failure contagion.
Options and Hedges
In finance, options are derivatives because they derive their value from an underlying asset. An option contract is an agreement between a buyer and a seller that gives the buyer the right, but not the obligation, to buy or to sell a particular asset on or before the option’s expiration date at an agreed price. In return for granting the option, the seller collects a payment or a consideration from the buyer.
Options can be used to speculate for profit or to hedge risk. The classic model of hedging, originally developed in 1949 by Alfred Winslow Jones (1910-1989), takes long and short positions in equities simultaneously to limit exposures to volatility in the stock market.
Jones, Australian-born, Harvard and Columbia educated sociologist turned financial journalist, came upon a key insight that one could combine two opposing investment positions simultaneously: buying stocks and selling short paired stocks, each position by itself being risky and speculative, but when properly combined would result in a conservative portfolio that could yield market-neutral outsized gains with high leverage. The realization that one could couple opposing speculative plays to achieve conservative ends was the most important step in the development of hedged funds, a term coined by a 1966 article in Fortune to describe the fund run by Jones.  
The manipulative power of options lies in their versatility. Options enable the buying party to adapt or adjust its position to handle any future situation that may arise. Options can be used speculatively with risk or protectively against risk to fit the buyer’s desire. This means an option buyer can do everything from protecting a position from decline to outright betting on the movement of a market or index for gain. Options are therefore merely passive versatile financial instruments. The users of options determine their purpose for their use.
Why Option Trading Needs to be Regulated
Regulating the options market has all the controversy of the debate on gun control.  Guns do not kill; only people kill; but guns make it easier for people to kill. Thus gun control is advisable even though it is not a final solution to purposeful or accidental killing. Further, guns should definitely be kept away from children who have not developed the mature faculty to handle a dangerous weapon properly. Similarly, the trading of options should be regulated to protect investors who do not fully understand the implications of their investment decisions by the use of options.
To facilitate varying cash flow needs of different participants in a transaction, payments can take the form of structured settlements which are agreements to pay a designated party a specific sum in periodic payments over an extended period, sometimes for a lifetime without definitive end, instead of a lump sum. The risk on the uncertain aggregate payout amount is assumed inherently by the design of the structure.
An option is a derivative whose value changes over time in relation to the performance of the underlying asset such as a stock. This makes the precise evaluation of outstanding value of options difficult for the human mind to decipher in a timely manner, making risk-managed trading problematic.
Options and Futures
A more complex version of an option is a futures contract, where the value varies with the value of an underlying commodity or security. A futures contract commits a party to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (the futures price). The contracts are traded on a futures exchange and as such they are not over-the-counter derivatives that are traded outside of exchanges between counterparties directly.
Futures contracts are derivative instruments. The price is determined by the instantaneous equilibrium between the forces of supply and demand among competing buy and sell orders on the exchange at the time of the purchase or sale of the contract.
It is useful to understand that futures and option contracts are not market prediction, but market implications that have been precisely calculable since 1973. Futures and option contracts are extensively used to manage risks involved in holding interest-sensitive stocks of firms whose earnings are affected by interest rates changes, such as banks, insurance companies, financial companies, utilities or any enterprise that deploys large amount of debt.
Black/Scholes/Merton Formula
In their 1973 paper, “The Pricing of Options and Corporate Liabilities”, Fischer Black and Myron Scholes published an option valuation formula which has become the standard method of pricing options. Black and Scholes derived a stochastic partial differential equation governing the price of an asset on which an option is based, and then solved it to obtain their formula for the price of the option. Robert C. Merton published a paper expanding the mathematical understanding of the options pricing model and coined the term “Black-Scholes” option pricing model. Merton and Scholes received the 1997 Noble Prize for Economics for this and related work.

Black and Scholes made path-breaking contribution to the growth of the option market by providing a mathematical calculation for precise pricing of an option, changing it from mysterious intuitive guesses to measurable rational implication.
Derivatives based on the yield performance of assets, interest rates, currency exchange rates and various domestic and foreign indices are now routine financial instruments that serve a wide range of risk management strategies. A key characteristic of derivatives is their ability to exploit leverage, which when used knowledgeably, can enhance returns for investors with appropriate appetite for risk, or be highly effective in hedging portfolios through the neutralization of risk exposures.
Black/Scholes merely made it possible to mathematically determine the precise and accurate price of an option, no more, no less. This simple feat in real-time accurate pricing in option markets was equivalent to the invention of accurate time keeping in milliseconds in computer science. It opened up the possibility of building mathematical models that aim at profiting from managing risk.
A lot of people since Alfred Winslow Jones have known that pairs of opposite bets can cancel risks. What was lacking was the precision needed to identify the true pair opposites.  Black/Scholes made it possible to precisely price every option trade in real time with a logic that the entire market accepts to be as reliable as the formula 2+2=4. But the market for complex reasons is never 100% efficient or rational. One reason is the aggregate tendency to overcompensate due to the herd instinct. Too many correct moves that individually compensates accurately for local errors can lead to a big aggregate overcompensation for internally generated systemic error.
Fischer Black and Myron Scholes found a partial solution to accurately price options in theory. But it was Robert Merton at Harvard who completed the mathematical formula. Merton’s father was a prominent behavioral scientist at Columbia who coined the concept of self-fulfilling prophecy. Merton studied mathematics at Cal Tech. Being mathematically trained and a gambler by instinct, (there were all kinds of stories about his gambling, how he would bet his annual salary in the market and live on loans collateralized by his holdings), Merton focused on prices in a series of infinitesimally minute time units, a process which came to be known as “continuous time finance”.
In the 1970s, one could not read any current literature in finance without coming across reference to Merton’s influential work. Merton translated the yet unpublished theoretical concepts of Black/Scholes by defining the relationship between an option and its underlying asset mathematically and came up with an elegant and easy-to-use formula that any college grad can use to trade options. But Merton, as a gentleman scholar, waiting for Black/Scholes to publish first. At the time of Balck/Scholes’ publication, it was merely an academic theory, because there was not yet an operating options market.

About three weeks before the B/S publication, the Chicago Board of Options Exchange began to list stock options for trading, but it was a very slow process. Not too long later, Texas Instrument came out with a hand-held calculator that had a Merton /B/S formula built-in. Soon, every young trader, many as second-year college drop-outs fresh from their first finance classes, was using a handheld TI calculator to trade options and was making more profit in a day than the college professors made a year.
The derivative market took off. When B/S/Merton won the Noble prize, young traders without exception were shouting “well deserved”. No one could have use the B/S/Merton formula profitably before the advent of the options market, and the option market could not have taken off without the TI calculator with a built-in B/S/Merton formula. Financial innovation, similar to scientific and engineering innovation, evolves from a coincidence of related breakthroughs.

The Black/Scholes math-based models can sweep the market in seconds and
identify inefficiencies and execute arbitrage trades to exploit market inefficiency. Derivative trades at first blossomed to reduce market inefficiency. It started as an exercise in portfolio insurance to mitigate risk, but as it became possible to mitigate risk, risk management actually allowed market participants to take on larger risk with a false sense of safety. Risk management then soon became a profit center, leaving the insurance part behind. The profit advantage of each trade is often very minute, that is why it takes a huge number of trades, with notional values in billion of dollars to made sizable profit. Soon, the notional value market became exponentially larger than the physical market.
Credit Default Swaps
Credit Default Swaps (CDS) are contracts in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument goes into default. CDS contracts have been compared with insurance, but it is different in many aspects. For one, a buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. It is in a way similar to buying insurance on the death of a total stranger, which would be illegal in insurance.
According to the Bank for International Settlements (BIS), total outstanding Credit Default Swaps (CDS) at year end 2007 was $43 trillion, more than half the size of the entire asset base of the global banking system. Total derivatives outstanding amounted to over $500 trillion in notional value, off the balance sheets of banks into those of Special Investment Vehicles (SIVs) with Collateralized Debt Obligations (CDOs) and other conduits comprising the highly leveraged shadow banking system. July 2007 was the month the credit market imploded globally. US GDP was only $14 trillion in 2008. It will take the US 36 years to produce $500 trillion in GDP.
Notional Value
Granted notional values are not the amount at risk. It is only a value on which derivative contracts calculate winning or losses. But a 3% net loss on a notional value of $500 trillion will wipe out the entire GDP in 2009.  The fact that much of this frenzy speculation was financed by debt made available by the loose monetary policy of the Greenspan Fed was of course a key contributing factor that fueled the derivative market.
Theory of Heterogeneous Expectation and Efficient Market Hypothesis
What ever else they were, Merton/Scholes were not charlatans. They were in fact astute philosophers of a finance technology revolution, managing risk by turning volatility against it, with the advantage of the law of large numbers within the context of the “Efficient Market Hypothesis”, the central idea of modern finance and globalization.
The Theory of Heterogeneous Expectation asserts that asset prices can be affected by investor expectations to create market inefficiency and peculiarity. False expectation leads to price bubbles because the market for longing an asset is generally easier to make inside an exchange than a market for shorting it. This gives rise to the OTC market where both long and short plays can be constructed at will.
The Upward Bias of Exchange-Traded Transactions
Legal and exchange rules limitation on shorting gives exchange traded prices an upward bias, allowing price bubbles long periods to build by negating the efficient market hypothesis. Also, the development of executive compensation through stock options rather than actual stocks meant, in addition to potential dilution of stocks, that executive compensation is aligned with stockholder interest only when stock prices rise, but not when stock prices fall. Management began to enjoy the security of a separate lifeboat from risk than shareholders.  When the down side of risk is removed from management, risk will be taken by management.      
Proprietary Trading
Every hedge fund uses its own proprietary models to exploit market inefficiency, but they are all based on the same logic of market efficiency hypothesis.  Derivative traders at first earned money only from incentive fees earned from trading profits hedging risks for clients. Soon traders became not satisfied with only the return they made from incentive fees from hedging for clients alone. They began taking proprietary speculative positions by entering into leverage funding agreements with banks and in time led banks to set up their own proprietary trading operations with off-balance-sheet risk exposure outside of their capital requirements.
The Problem of Large, Complex Banking Organizations
In my May 2002 AToL article: BIS vs National Banks, I warned:
“… assessment of risks is complicated by recent structural financial developments in the advanced nations’ financial systems, including increasing global market power concentration in large, complex banking organizations (LCBOs), the growing reliance on over-the-counter (OTC) derivatives and structural changes in government securities markets. Despite all the talk of the need for increased transparency, these structural changes have reduced transparency about the distribution of financial risks in the global financial system, rendering market discipline and official oversight impotent.
Even blue-chip global giants such as GE, JP Morgan/Chase and CitiGroup have overhanging dark clouds of undisclosed off-balance-sheet risk exposure. Ironically, banks in emerging markets are penalized with disproportionate risk premiums when they fail to meet arbitrary BIS Basel Accord capital requirements, while LCBOs with astronomical risk exposures in derivatives enjoy exemption from commensurate risk premiums.”
(The auto giants were not mentioned because even in 2002, they were no longer considered as blue-chip companies.)
The Bank for International Settlements, which sets capital reserve requirements for banks, instead of focusing on balancing risk, developed Basel II to impose capital reserve on LCBOs against capital losses from high risk derivative transactions.
Under Basel II, a bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as Exposure at Default (EAD), in the bank’s internal systems. All these loss estimates should seek to fully capture the risks of an underlying exposure. In general, EAD can be seen as an estimation of the extent to which a bank may be exposed in the event and at the time of a counterparty default. It is a measure of potential exposure as calculated by a Basel Credit Risk Model for the period of one year or until maturity whichever is sooner. Based on Basel Guidelines, EAD for loan commitments measures the amount of the facility that is likely to be drawn if a default occurs. The contagion effect of a chain of EAD is a key component that makes loss estimates difficult to pin down. (Please see my May 13, 2009 article: Stress Tests for Banks)

Banks used to set up derivative trades as a service to clients for a nominal fee. Then their bond trading department began doing “proprietary” trading with the banks funds, exposing banks to risks of huge profits and losses. By 2007, all banks have gotten into the derivative game up to their necks, as did all investment banks and even commercial banks. The profit potential of 40% return annually was simply irresistible. Several central banks were also playing this game, some even today. The Bank of China was an investor in Long Term Capital Management (LTCM) and was the Central Bank of Italy. Both lost huge sums when LTCM collapsed in 1998.

The Rise and Fall of LTCM
No financial system can sustain returns of 40% perpetually. Such returns can only be produced by speculation. Thus the systemic risk was built into the system when derivatives were used to produce profit rather than to mitigate risk of loss. But immediate risk in the OTC derivative market is counterparty default. Counterparty risk could turn virtual winnings into actual losses, since it is a zero sum game. Further, counterparty default can be highly contagious to detonate systemic consequences. That is the main reason the Fed was forced to bail out LTCM, because LTCM was the counterparty to many of the banks’ trades, in addition to being a big borrower. It was all very financially incestuous.

LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. LTCM board directors included Scholes and Merton. It accepted investments from 80 investors who put up a minimum of $10 million each. The initial equity capitalization of the firm was $1.3 billion.
Initially enormously successful with annualized returns of over 40% after fees in its early years, LTCM’s enormously leveraged arbitrage plays involving more than $1 trillion dollars went bad in 1998, resulting in a $1.9 billion loss in one month, and a $4.6 billion loss in less than four months following the Russian sovereign bond default. The final loss was $5.85 billion, a record at the time. But six year later, in 2006, Amanranth Advisors lost $6.7 billion in gas futures placed by a star trader (Brian Hunter) and in 2008, Société Général lost $7.1 billion from trading fraud by a young trader (Jérome Kerviel) in European Index futures. The trend suggests that no lessons have been learned about the failure of market self regulation.
LTCM’s extensive derivative contracts with banks and other institutional investors worldwide threatened a global market seizure if it should default on its obligations, which prompted the Federal Reserve Bank of New York to step in to organize a bailout with the affected major banks. The fund folded in early 2000, but the real damage was an increase of moral hazard in the finance industry.
Meriwether had assembled an all star-team beyond theoretical gurus at the founding of LTCM, including David Mullins, a Vice Chairman of the Federal Reserve and expert on financial crises, who wrote the White House Report on the 1987 crash, blaming it on derivatives, also served as Assistant Secretary of the Treasury for Domestic Finance in the George HW Bush administration. When disaster hit, Mullins through his old connections brought in the Fed for a quick bailout.
Merton and Scholes were not actually doing the trading for LTCM. They only provided the theoretical strategy. They did not see LTCM as a mere hedge fund, but as a state of the art “financial intermediary”, a new generation of shadow banking. Unlike old fashion banks who deal with clients they personally know, LTCM remotely matched liabilities with assets globally in a virtual market, rather than locally as banks used to do as pillars of their communities. LTCM borrowed by selling one bond and lent by buying another bond, often foreign bonds with different fundamentals, and profited from the spread in both interest rates and currency exchange rates. Most of the time LTCM traders did not know, or did not care, who were the final sellers or buyers as long as the trades were channeled through acceptable broker/dealers and properly hedged. LTCM was in the highly profitable business of enhancing global market efficiency and of providing liquidity to the market. It had no loyalty to any particular nation or community, working solely on the principle of survival of the fittest. At the end, LTCM was brought down by an irrationally inefficient market when Russia defaulted on her sovereign bonds because Washington refused to come to her aid and by a mega liquidity crunch that LTCM itself could not provide.

LTCM employed complex mathematical models to take advantage of fixed income arbitrage deals through a strategy of convergence trades of G7 sovereign bonds. Government bonds are “fixed-term debt obligations” because they will pay a fixed amount at a specified time in the future. Differences in the present value of different bonds are minimal, as according to equilibrium theory any difference in price will soon be eliminated by arbitrage. Unlike differences in share prices of two companies, which could reflect different underlying fundamentals, price differences between a new 30 year Treasury bond and a 29-and-three-quarter-year-old Treasury bond should be minimal, as both will see a fixed payment roughly 30 years in the future. However, small discrepancies can arise between the two bonds because of a difference in liquidity. By a series of financial transactions, essentially amounting to buying the cheaper “off-the-run” bond (the 29-and- three-quarter-year-old bond) and shorting the more expensive, but more liquid, “on-the-run” bond (the 30 year bond just issued by the Treasury), it would be possible to make a profit as the spread in the value of the bonds narrowed when another new bond is issued. On this principle, LTCM scored huge profits with high off-balance-sheet leverage achieved with sophisticate and complex hedges. It also invested in long positions in emerging markets sovereigns, hedged back to dollars.
As LTCM scored enviable returns, its capital base grew beyond the market for profitable bond-arbitrage trades. To maintain market expectation of high return on asset under management, LTCM was pressured to undertake more aggressive trading strategies. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up or down, meaning they were market neutral, they were no longer strictly pure convergence trades, but convergence trades subject to exogenous impacts.
By 1998, LTCM had very large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). LTCM had also become a major supplier of S&P 500 vega which measures sensitivity to volatility. Vega is the derivative of the option value with respect to the volatility of the underlying asset, and was in demand by companies seeking to essentially insure equities held against future declines.
Because these differences in value were minute—especially for the convergence trades—LTCM needed to take highly-leveraged positions to make profit of consequence. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. It had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equal to 5% of the entire global market.  LTCM also invested in other derivatives such as equity options.
After two years of returns running close to 40%, the fund has some $7 billion under management. But by the end of 1997, LTCM was achieving only a 27% return — comparable with the return on US equities that year. LTCM returned $2.7 billion of the fund’s capital back to investors citing as reason “investment opportunities were not large and attractive enough.”  This was a strategic error, as the reduction of capital adversely affected LTCM’s ability to withstand a liquidity crisis a few months later.
Trouble at LTCM began in May and June 1998 when net returns fell to minus 6.42% and minus 10.14% respectively, reducing LTCM’s capital by $461 million. This was further aggravated by the distressed exit of Salomon Brothers from the arbitrage business in July 1998. There were sign that these losses could not be explained by temporary volatility.
LTCM’s trading strategy finally unraveled in August and September 1998 when the Russian government defaulted on its sovereign bonds (GKOs). Panicked investors sold Japanese and European bonds to buy US Treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged from sudden market aversion of risk. By the end of August, LTCM had lost $1.85 billion in capital. The company, which had been providing annual returns of almost 40% up to this point, experienced a sudden and massive “flight to liquidity” by its investors.

The investors in LTCM were all sophisticated professionals: individuals who had made hundreds of millions themselves and sophisticated institutions who were major market players, including central banks. Central banks as a rule do not invest in hedge funds, but LTCM was not simply another hedge fund, but a market leader in a new financial market. Barclays was also an investor as well as a big proprietary trader with its own account. In fact, when swap spreads, the basic thermometer of the credit market, rose in late August, 1998, Barclay traders were ordered by top management to unload short positions in UK swaps, even though the Barclay traders, like those at LTCM, thought the higher spread could not hold and convergence would soon return. But Barclay had enough of risk and its decision on Thursday August 20, pushed the spread even higher, and the next day the run started all over the world, and LTCM was facing imminent collapse.
LTCM had counterparty trades with nearly every institution of importance in the world, including all 15 largest commercial and investment banks. As LTCM teetered, Wall Street feared that its failure could cause a chain reaction counterparty default in interconnected markets around the world, causing catastrophic losses throughout the global financial system. As LTCM attempted desperately to raise needed cash on its own to honor its extensive commitments, it became clear to the market that a default was imminent.
The fear was that there would be a chain reaction as the firm liquidated its positions to cover its debt, leading to a sharp drop in prices, which would force other firms to liquidate their own debt creating a vicious cycle of fire sale.
On September 23, under the auspices of the NY Federal Reserve Bank, a group including Goldman Sachs, AIG, and Warren Buffet’s Berkshire Hathaway offered to buy out LTCM partners for $250 million and to inject $3.75 billion to take over LTCM and fold it into Goldman’s own trading division. The offer was stunningly low as at the start of the year, LTCM partners positions were worth $4.7 billion. Buffet gave Meriwether less than one hour to accept the deal. As it happened, the time period lapsed without a deal.
If LTCM had not returned $2.7 billion of its capital to investors, it might have been able to withstand the crisis.
Seeing no market options left, the New York Fed organized a bailout of $3.625 billion by 14 of the 15 LTCM major creditors to avoid a wider collapse in the financial markets: $300 million each from Bankers Trust, Barclays, Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, Solomon Smith Barney, and UBS; $125 million from Société Générale; $100 million each from Lehman Brothers and Paribas; while Bear Stearns alone declined to participate.
This refusal to play ball on the part of Bear Stearns would come back to haunt it in 2008 when Bear Stearns needed help to avoid collapse. Bear Stearns pioneered the securitization and asset-backed securities markets, and as investor losses mounted in those markets in 2006 and 2007, the company actually increased its exposure, especially the mortgage-backed assets that were central to the subprime mortgage crisis. The Hail Mary bet failed. In March 2008, the New York Fed had to provide an emergency loan to Bear Stearns to try to avert a sudden collapse, but the firm could not be saved. The New Yrok Fed then arranged for JPMorgan Chase to acquire Bear Stearns, with a Fed guarantee, for as low as $10 per share, far below the 52-week high of $133.20 per share before the crisis, although not as low as the $2 per share originally agreed upon by Bear Stearns and JP Morgan Chase without a Fed guarantee.
In return for bailing out LTCM, the participating banks received 90% of LTCM shares and a promise that a supervisory board would be established. LTCM’s partners received a 10% stake, still worth about $400 million, but this money was completely consumed by their debts. The partners once had $1.9 billion of their own money reinvested in LTCM, all of which was wiped out.
LTCM’s total losses added up to $4.6 billion. The losses by major investment categories were: $1.6 billion in swaps, $1.3 billion in equity volatility, $430 million in Russia and other emerging markets, $371 million in directional trades in developed countries, $286 million in equity pairs (such as VW, Shell), $215 million in yield curve arbitrage, $203 million in S&P 500 stocks, $100 million in junk bond arbitrage and no substantial losses in merger arbitrage.
After the bailout, when the panic abated, the positions formerly held by LTCM were eventually liquidated at a small profit to the bailers. But the real damage was a sharp rise in moral hazard in the financial market that contributed to the crisis of 2007.
The profits from the LTCM trading strategies were generally not correlated with each other and thus normally LTCM’s highly leveraged portfolio would be protected by diversification. However, the general flight to liquidity in late summer of 1998 led to a market-wide re-pricing of all risks and these separately leveraged positions all moved in the same direction, neutralizing the effect of balance in diversified portfolios. As the unanticipated correlation of LTCM’s positions increased, the diversified benefits of LTCM’s portfolio vanished and large losses to its equity value accumulated exponentially.
Value at Risk as a Risk Management Tool
Thus the primary lesson of the 1998 crisis and the collapse of LTCM for Value at Risk (VaR) users is not one of liquidity, but more fundamentally that the underlying covariance matrix used in VaR analysis is not static but dynamic over time. LTCM was a victim of a massive “VaR break”.
In financial mathematics and risk management, VaR is a widely used risk measure of the risk of loss on a specific portfolio of financial assets in terms of probability and time horizon. VaR is a threshold value of the probability that the mark-to-market loss in a portfolio over the given time horizon.
For example, a portfolio of stocks with a one-day 5% VaR of $1 million has a 5% probability that the portfolio will fall in value by $1 million over a one trading day period, assuming markets operate normally and there is no compensating trading by the portfolio. Operationally, a loss of $1 million on this portfolio can be expected on 1 day in 20. The portfolio is considered risk managed if over the 20-day period, the gain is over $1 million to cover the possible loss of $1 million. A loss which exceeds the VaR threshold is termed a “VaR break.”

LTCM had a VaR of between $3-5 million for any given day. In August 1998, its VaR rose 100 times to $300-500 million for any given day.  In the end, the basic convergence model used by LTCM remained operative in that the values of government bonds did eventually converge but only after the company had been wiped out.

Based on the derivative side of its books, LTCM had an astoundingly high debt-to-capital ratio. According to transcripts of the September 29, 1998 meeting, a desperate Peter Fisher, Executive Vice President of the NY Fed and account manager of the Fed Open Market Committee, told Chairman Greenspan and other Fed governors: “The off-balance sheet leverage was 100 to 1 or 200 to 1 -- I don’t know how to calculate it.” 
Fisher went on to become Under Secretary for Domestic Finance of the Clinton Treasury in 2001, and later in 2004 a BlackRock Managing Director and a member of the firm’s Management Committee with primary responsibility for expanding the firm’s balance sheet advisory services.
BlackRock is one of the world's largest publicly traded investment management firms with employees in 21 countries throughout the Americas, Europe and Asia Pacific. As of 30 September 2009, BlackRock’s assets under management total US$1.435 trillion across equity, fixed income, cash management, alternative investment and real estate strategies, offering risk management, strategic advisory and enterprise investment system services to a broad base of clients with portfolios totaling approximately US$7.25 trillion, almost half of US GDP.
The Sharpe Ratio
The Sharpe ratio, developed by William Forsyth Sharpe, (or reward-to-variability ratio) is a measure of the excess return (or Risk Premium) per unit of risk in an investment asset or a trading strategy. The return on a benchmark asset, such as the risk free rate of return is the expected value of the excess of the asset return over the benchmark return. The standard deviation of the asset excess return is a constant risk free return throughout the period.
The Sharpe ratio is used to characterize how well the return of an asset compensates the investor for the risk taken. When comparing two assets each with the expected return against the same benchmark risk free return, the asset with the higher Sharpe ratio gives more return for the same risk. Investors are often advised to pick investments with high Sharpe ratios. However like any other mathematical model, it relies on the data being correct. Pyramid schemes with a long duration of operation would typically provide a high Sharpe ratio when derived from reported returns, but the inputs are false.
When examining the investment performance of assets with smoothing of returns the Sharpe ratio should be derived from the performance of the underlying assets rather than the fund’s returns. Sharpe ratios are often used to rank the performance of portfolio or mutual fund managers.
The Sharpe ratio has as its principal advantage that it is directly computable from any observed series of returns without need for additional information surrounding the source of profitability. Unfortunately, some users are carelessly drawn to refer to the ratio as giving the level of ‘risk adjusted returns’ when the ratio gives only the volatility of adjusted returns when interpreted properly.
Given that a hedge fund manager typically aims for a Sharpe ratio of greater than 1.0, a Commodity Trading Advisor (CTA) manager with a Sharpe ratio of .19 would do poorly under this criterion. A Sharpe ratio of 1.0 would suggest that the relevant percentage of return and risk is about even. A Sharpe ration of 2.0 is excellent but probably cannot be sustained for long. But the Sharpe ratio has its own set of difficulties as a performance measure. In September 1996, after 31 months of operation, Long Term Capital Management (LTCM) reportedly had a Sharpe ratio of 4.35 (after fees). With the benefit of hindsight, we can say that LTCM’s realized Sharpe ratio after two and a half years of operation did not give a meaningful indication of how to evaluate its investments.
LTCM started with $1.3 billion in initial assets and focused on bond trading. The trading strategy of the fund was to make convergence trades, which involve taking advantage of arbitrage between securities that are incorrectly priced relative to each other. Due to the small spread in arbitrage opportunities, the fund had to leverage itself highly to make money. At its height in 1998, the fund had $5 billion in capital, controlled over $100 billion of assets and had positions whose total worth was over a $1 trillion in notional value. Soon, it had to cut its capital down by more than half ($2.7 billion) without correspondingly reducing to risk exposure in an increasingly risk adverse market in order to maintain accustomed high return. All it did was to increase its Sharpe ratio.

Due to its highly leveraged nature and a financial crisis in Russia related to the default of sovereign bonds which led to a flight to quality, LTCM sustained massive losses and was in danger of defaulting on its extensive financial commitments. The size and breath of its positions made it difficult for LTCM to cut its losses in its positions without also wiping out still profitable positions. LTCM held huge positions in the market, totaling roughly 5% of the total global fixed-income market. LTCM had borrowed massive amounts of money to finance its leveraged trades. Had LTCM gone into default, it would have triggered a global market seizure and financial crisis, caused by the massive write-offs its creditors would have had to make. In September 1998, LTCM, which continued to sustain losses, was bailed out with the help of the Federal Reserve which brokered a creditor takeover. A systematic meltdown of the market was thus prevented at the last moment, with significant rise in moral hazard.
Volatility tends to come in lumps, as volatility tends to breed more volatility. The LTCM near collapse and the Russian debt crisis showed that high volatility would stay with the markets for extended time periods even after the precipitating events had subsided. Some market observers believe major volatility events tend to occur every four years inherent in the structural dynamics of deregulated financial markets.

Next: The Courageous Brooksley Born