Presented at the 17th Annual International Organization of Securities Commissions (IOSCO) Conference
Mexico City, Mexico
October 27, 1993

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In 1974 I participated in the proceedings before the U.S. Congress that gave rise to the Commodity Futures Trading Commission (CFTC), the primary regulator of futures markets in the United States. I was then and remain today a supporter of this federal agency, indeed, I was a leading proponent of the creation of the CFTC and helped frame its structure. However, then as now, I was mindful that every federal agency is, at best, a mixed blessing. For while regulatory bodies are always created with the best of intentions and can benefit the private sector, they inherently contain the mechanisms with which to veer from their intended course and become an impediment or even a destructive force.

Mindful of this fact, I testified that the proposed legislation had within it some onerous provisions that would allow the CFTC—wittingly or not—to impede innovation. Specifically, I was referring to the broad justification provisions that required a contract market to prove the economic and public interest of a proposed futures contract in order to receive federal approval. I brazenly argued before Congress that, "Pioneerism needs no economic justification"—only the market itself can provide such proof. In retrospect, I like to believe that my testimony made a difference in the subsequent application of the economic justification test by the CFTC. Indeed, I doubt very much whether in 1972—before the demise of the fixed exchange rate system of Bretton Woods—I could have proved there was an economic or public need for a financial derivatives market such as that represented by the foreign currency futures of the International Monetary Market of the Chicago Mercantile Exchange (CME).

Today, a similar dilemma exists for the regulators of world markets as they wrestle with the problems posed by modern financial markets and present day innovations. Consequently, I welcome the opportunity to address the members of IOSCO in order to caution and implore that, in your desire to better world markets, you not inadvertently make them worse. For you have it in your power to do both. It cannot be overstated: In today's global economy—forged as a consequence of technology and informational flows—market regulators as never before face daunting tasks brimming with challenge and fraught with danger.

The world has changed substantially and dramatically since IOSCO was formed in 1974. Indeed during the past two decades the transformations our civilization has endured in science, technology, economics, and politics nearly defy comprehension, and are of such magnitude that they cannot be described in fewer than volumes of written words. However, for the purposes of this conference, allow me to extract the one over-riding principal that impacts those of us in the markets: The world has confirmed that economic and political freedom form the quintessential foundation for economic success.

One need only look at the miraculous metamorphosis occurring in Latin America in the last decade to confirm this truth. The Latin transformation was born out of the failed policies of the 1960s and 1970s which are analogous to those attempted by the former Soviet Union—managed national economic goals based on a structure of authoritarian control over the population. In South America these policies resulted in state owned industries and private monopolies, autarky promoted by tariffs and export levies, huge external debt, archaic financial concepts and laws, hyper-inflation, unstable currencies, and undercapitalized markets. From that unfortunate history, Latin America—from the Rio Grande to Tierra del Fuego—has begun its difficult journey to democratic rule coupled with economic reform based on a market driven order—Milton Friedman's prescription for economic success.

The results to date have been amazing: Elected governments have replaced military dictators; old interventionist and protectionist policies are being replaced with free trade concepts and agreements; managed economics has been discarded in favor of market-driven principles; state ownership is being replaced by privatization; and free wheeling and unplanned economic policies have been abandoned in favor of tight fiscal and monetary control. This positive transformation of Latin American and Mexico, in particular, has not been lost on the rest of the world. Indeed, if current trends do not materially falter, as we enter the next century, this vibrant and influential continent could very well take its proper place among the economic powers of the new world order.

Thus, the fundamental precepts of Adam Smith and Thomas Jefferson are making their mark in Mexico as they are in every corner of the globe.

Among the important missions yet ahead for Mexico and Latin America is the development of a broad and liquid futures market as well as a sophisticated Over-the-Counter (OTC) derivatives market. These markets are vital to the successful development of a market economy. This represents a fundamental fact of economic life in today's world, one that is imperative for every emerging economy—be it in Latin America, Eastern Europe, or the Pacific Rim—to understand. It is an equally essential principle for the members of IOSCO to recognize.

We live in a highly complex and dangerous economic environment, one in which financial risks differ dramatically from those of two decades ago. We live in a world in which competition is global, financial volatility is constant and commonplace, and opportunities rapidly appear and disappear on a constantly changing financial horizon. We live in a world that demands products to protect us from inherent financial risks, that demands cost-efficient instruments to adjust portfolio exposure between securities and cash, that pays a premium for credit-worthy mechanisms which preserve credit lines, and that necessitates the expertise of asset allocation and market-timing for sound money management.

In today's world, the magic of technology has enabled us to divide risk into its separate components and to devise instruments that secure their values from other assets. We have evolved from simple futures contracts in foreign exchange, eurodollars, and bonds, to complex swaps and swaptions, strips and straps, collars and floors. We have created and are continuing to create an endless flow of products that are limited only by the needs of the participants and the imagination of the financial engineers who invent them.

During the first decade of derivatives use, dealers spent most of their time with corporate treasurers who were almost exclusively interested in reducing their exposure to interest-rate and currency risks. Joe Argilagos, in charge of Merrill Lynch's Investor Service Group, one of the earliest players in the investor derivatives, states that during the eighties, "everybody was using their derivatives capability to approach issuers and bring them a variety of alternatives to access capital markets around the world."(1)

But in the second decade of derivatives, innovation shifted from the corporate to the investor side. "1992," says Mr. Argilagos, "was the year when derivatives entered the mainstream for investors." He explains that now you have to create "a conduit for investors to access the markets, so that they could understand them and manipulate them from their standpoint."

1992 was also the year when the derivatives market was discovered by mutual funds and money managers trying to find ways to outperform their competitors. It began, explains Jim McNulty, managing director of Swiss Bank Corp., with the 1987 stock crash. Before then, he stated, "almost no mutual fund fixed income managers were using these structures. After the crash, there was an explosion overnight in global bond funds as more people move out of the stock market."(2)

The investor side tends to drive you into a more structured and sophisticated marketing effort, says Senior vice president of Natwest, Zahid Ullah. "You need a wide product range, and you need to be in exotic products." That to him means interest rate swaps, quantos, yield-curve swaps, and LIBOR squared products. He also point out that "the investor side is highly sensitive to the level of rates and the shape of the curve. Dollar-based investors are clamoring for high yields that don't generate any currency risks."(3)

Min Hee Kim, a risk management vice president at Chemical Bank, points out that "five years ago our traditional customer was a liability manager who wanted to hedge against rising rates." Now, he states, "we're dealing with a much more aggressive type of user," one who is willing to increase risk, by exchanging some marginal unit of risk for marginal extra return. For instance, Min Hee Kim, explains, "hedge funds are using derivative products to create a risk not easily available in the liquid markets. They might be looking for long-dated options, or volatility risk not available on a futures exchange.(4)

The foregoing private sector applications of derivatives represent but a small sample of this exploding market. These products cover the full gamut of financial risk and, I must add, the entire alphabet from A to Z, for example:

From Agios, (a bond's market value premium over par, expressed as percent) to Z-bonds (an accrual tranche of a collateralized mortgage obligation --usually one of the last segments to be paid off in cash);

from Baseball Options, (Options which become in, out, or explode in an early exercise trigger when the exercise price is touched. A baseball option: three touches of the outstrike and you are out.) to You Choose Warrants (as apposed to As-You-Like Warrants; A warrant with a provision permitting the purchaser to designate it as either a call warrant or a put warrant for a limited period.);

from Concertina Swaps, (a variable notional principal swap that uses the present value of an existing fixed-rate paying swap position to increase an issuer's near term protection from high floating rates) to Window Warrants (warrants which can be exercised only during limited intervals in the life of a host bond);

from Delta/Gamma Hedges, (a risk offsetting position -- consisting in part of short-term option contracts) to a Vertical Bull Spread (Regardless of whether two puts or two calls are used to create this option spread, the option purchased has a lower strike than the option sold.);

from EYES, (Equity Yield Enhancement Securities) to Up-and-In Options (path-dependent options -- depends on whether they go up and in the strikes, etc.);

from FANs, (Fixed Assurance Notes), to Tail Hedging (adjusting the number of futures contracts in a hedge position so that the present market exposure of the hedge offsets the underlying exposure);

from GRIPs, (Guaranteed Return on Investment Certificates) to Sandwich Spreads (akin to Butterfly and Alligator spreads);

from Hindsight Currency Options, (an option giving the buyer the retroactive right to buy a currency at its low point or to sell a currency at its high point within the option period) to Rainbow Options (A call option with a payoff based on the amount by which one of several underlying instruments outperform the others.);

from Index Allocated Principal Bonds, (a collateralized mortgage obligation whose principal paydown is allocated according to the value of some index) to Quasi-American Options (Like the Bermuda option, it can be exercised on a number of predetermined occasions.);

from Jellyrolls, (a transaction in offsetting long and short synthetic stock positions created from options with identical strike prices but different expiration dates) to Poison Puts (a provision of a bond or note which makes the instrument puttable to the issuer following a change of control or a restructuring which reduces the credit quality of the issue);

from Kickers, (A sweetener; a right, warrant, or other low value security added to a debt or stock offering to improve the market reception of the entire issue) to One Touch Options (See baseball option.);

from Ladder Options, (an index or currency warrant or option that provides an upward reset of its minimum payout when the underlying touches or trades through certain threshold levels.) to Mini-Max Floaters (a floating rate note with an embedded collar.).(5)

I could go on and on.

We live in a world where these instruments are used to protect against changes in revenues and expenses resulting from exposure in interest rates and exchange rates; where these instruments are used to manage assets and liabilities; where these instruments are used to enhance equity and fixed income portfolio performance; where these instruments are used to protect against commodity price rises or mortgage interest costs. As a consequence of their application, risks are reduced and profit is increased over a wide sphere of financial enterprise and in various ways—from businesses whose efficiency is enhanced, to banks whose depositors and borrowers are benefited; from investment managers who increase their performance for clients to farmers who protect their crops; and from commercial users of energy to retail users of mortgages.

We must also not underestimate the role derivatives play in a macro-economic sense, that is, their function in increasing the liquidity within capital markets and in developing more efficient global intermediation processes. By acting as a catalyst for the integration of various markets, these instruments serve to foster rapid growth in international trade and capital flows, allowing excess savings in one market to be channelled into another. This process offers assistance to emerging capital centers by funneling investment of savings from mature industrialized countries into higher yielding opportunities in developing nations. University of Chicago Professor Merton Miller, the 1990 Nobel laureate in Economics, stressed this point in his remarks last year to the Mexican Securities Market as he urged Mexican authority to allow the creation of index derivatives markets. "What you can essentially do with index futures," he stated, "is to leave the physical assets in place while moving their returns."

The foregoing direct as well as tangential benefits of derivatives markets to a market economy are unfortunately understood only to a limited extent and with varying degrees of comprehension among the governments of the world. They are frequently seen as suspect and often misunderstood. The consequences of such uneven awareness are unfortunate and can be dangerous. One need only examine the recent effects to Japanese financial futures markets to cite the deleterious consequences stemming from burdensome regulations. Moreover, the difficulties faced by GATT and NAFTA are salient examples where lack of comprehension and misinformation can lead. It is a direction in opposition to the overriding needs of today's interdependent world: Free trade, as well as coordination and harmonization of the regulatory thicket effecting world markets.

The value I have attributed to futures, options, and OTC derivatives is not to be interpreted as a position against any form of regulation. Derivative markets are not without risk, nor do we fully understand all the nuances of the risks these instruments represent. Still, my attitude is a far cry from those who have sounded the alarms of panic, i.e. that "26-year-olds with computers are creating financial hydrogen bombs."(6) I also disagree with Bundasbank's recent warnings that the growth of global derivatives markets could endanger the stability of the world financial system.(7) Such blanket indictments are far too simplistic. That is not to imply that the world's financial system is not vulnerable to a major shock; indeed, for many good reasons, I believe it is, but I do not believe derivatives are the paramount cause for these concerns. Instead, I fully endorse the recent "Group of Thirty Study," chaired by Paul Volcker, former chairman of the Federal Reserve Board, which concluded that:

"Derivatives by their nature do not introduce risks of a fundamentally different kind or of a greater scale than those already present in the financial markets. Hence, systemic risks are not appreciably aggravated, and supervisory concerns can be addressed with the present regulatory structures and approaches."(8)

In other words, derivatives do not result in the creation of a greater quotient of risk than that which already exists in today's complex financial environment. As Wayne Angell, U.S. Federal Reserve Board governor, recently stated, "I consider derivatives simply a product of the free market system."(9) I also embrace the Group of Thirty Study's major recommendations for regulators and legal authorities, to wit:

That netting, or the multi-lateral closing out of unrealized gains and loses in the event of a counterparty's default, is "the most important means" of mitigating credit risk and systemic risk.

That regulators identify and end legal and regulatory uncertainties in the use of derivatives and the enforcement of netting and derivatives contracts.

That disadvantaged tax treatment of derivatives should be ended.

That more uniform international accounting standards should be adopted.

On the other hand, I do agree with the criticism of the Group of 30 study made by the Vice President of the Federal Reserve System's Board of Governors, David W. Mullins, Jr., who said the study lacked a rigorous examination of the appropriate capital levels required to support the risk associated with derivatives. I would also support the need for stricter accounting rules with respect to these instruments. However, irrespective of regulations, I have little doubt that the age of derivatives is upon us and will continue to grow unabated.

Hopefully, my remarks today will dispel some of the uncertainty about the application of these financial instruments, serve to explain their benefits to the underlying cash markets, and confirm their constructive effects on a market economy. My mission here, however, would be incomplete if I did not at least offer a glimpse of what the markets of the future hold in store.

First, the logical consequence of globalization and technology will result in regional as well as global electronic markets that either encompass the entire trading regime of a given exchange—such as the Deutsche Terminbörse and NASDAQ—or interconnect to open-outcry business hours, such as is the case of the CME and CBOT. In either case there will be systems such as GLOBEX to extend the business day and provide the competence of a complete 24-hour trading mechanism. Not only is the handwriting on the wall, its appeal nearly universal, its logic inescapable, but the world has been advancing toward this objective since the onset of the technological revolution.

Nor are we finished with market innovation. Indeed we are poised for yet another quantum technological leap into what is generally known as Artificial Intelligence (AI). There are some five basic approaches to this revolutionary trading concept, each at a different stage of development:

Neural Networks. A highly sophisticated trading system which tries to mimic the human brain process and learns from its mistakes. Modeled after the complex pathways of the human nervous system, such nets search for patterns in vast streams of data, learn from experience, and develop rules to recognize these patterns.

Expert Systems. These systems have, in fact, become the most used AI systems in corporate America today. The technology represents a computerized decision-making technique that embodies knowledge gleaned from experts. These judgment programs remove irrelevant trading ideas and accept the practical.

Genetic Algorithms. A problem solving technique useful in identifying and handling anomalies. As in a Darwinian universe where only the fit survive, such software procedures reject formulas that do not work, and steer the system in the right direction, assuring that "only the good cells live."

Chaos Theory. First introduced in 1975 by James Yorke and made popular today by James Gleick, this theory holds that seemingly random events, such as stock prices, actually have patterns that computer programs can detect. Physicists and mathematicians believe that, properly observed, apparently random events like the movements of stock prices will show themselves to be, if not predictable, then at least decipherable. In other words, chaos programs will not necessarily show where the market will go, but rather where it will not go.

Fractals: Similar to the chaos theory, fractals attempt to explain "nonlinear" configurations such as clouds or the movement of securities markets.

Like alchemists of the medieval period trying to create gold from lead, their modern-day equivalents apply state-of-the-art computer technology to markets with a similar intent of turning their trades into gold. While the application of this technology to the markets is still in its infancy and while its ultimate value is still unknown, rest assured it is on its way. Many major American brokerage firms have spent hundreds of millions, perhaps billions, of dollars on the development of this technology because it offers such explosive growth potential. Much of their work is top secret, "Those who know don't tell and those who tell don't know." One cannot even begin to assess the future regulatory problems posed by these systems, however you can be certain that the members of IOSCO will have their hands full.

Allow me to conclude by offering this summation: In our global market environment—an environment driven by instantaneous information flows and sophisticated technology—financial risk is ubiquitous and unending. Its management will continue to be the fundamental goal of investors and money managers. Futures, options, and OTC derivatives provide the ability to identify, price and transfer existing risks. They are the premier tools of risk management and are essential in a market economy. They will successfully render this service only as long as world markets are permitted to remain free, allowed to draw upon the ingenuity and creativity of their participants, and so long as market regulations are logical, practical, and harmonized across geographical borders. In sorting out the difficult issues raised by the use of derivatives, it is imperative that the world's regulators remember these vital truths.


     (1) Derivatives Strategy, a publication specializing in surveying Derivatives users and applications; Vol.2, No.1, July 5, 1993.

     (2) Ibid.

     (3) Ibid.

     (4) Ibid.

     (5) Dictionary of Financial Risk Management, Probus Publishing Company, 1992, Gary L. Gastineau, author; prepared and distributed by Swiss Bank Corporation, New York Branch.

     (6) Statement attributed to Felix Rohatyn, senior partner at Lazard Freres & Co., as reported by Jonathan R. Laing, "The Next Meltdown," Barron's, 7 June, 1993.

     (7) Financial Times, October 22, 1993, p.17.

     (8) Quoted by Barry B. Burr, in an article titled, "Mark derivatives to market study says," Pensions and Investments, 9 August 1993, p. 4.

     (9) Ibid, Financial Times

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