Fighting prejudice

The derivatives industry fights a running battle to counter the prejudices against it in the outside world that have primarily been caused by scandals such as Barings and Enron.

Sometimes, those of us attached to this industry can forget, or ignore, just how strong, and negative, this prejudice can be.

In December, a fictional documentary – or mock-u-mentary in the twenty-first century vernacular – was shown on television in the UK by national broadcaster the BBC, entitled The Man Who Broke Britain. The programme-makers clearly hoped that the realism in documentary style – which included using ‘media coverage’ from other broadcasters such as CNBC using real presenters – would prevent viewers looking too closely into the fantasy of the underlying story.

And the story? A rogue trader at investment bank SFCB (I bet Credit Suisse’s lawyers enjoyed that) had written hundreds of billions of dollars-worth of oil futures contracts with knock-out options if the oil price reached $75 a barrel. After a terrorist attack destroyed the Gulf’s main refinery, the oil price rose inexorably to the $75 mark. The trader behind the contracts disappeared. Police suspected he was a terrorist who had deliberately written these contracts knowing an attack would take place, in an attempt to bring down the global financial markets. In this tale, losses spread like wildfire across each of the world’s financial centres as contracts unwind and systemic losses are incurred.

There was a twist in the tale. The trader wasn’t a terrorist at all. The contracts had been written by his boss, seeking to reduce the premium that had to be paid for the contracts to generate business and meet his end-of-year bonus target. One greedy and unscrupulous trader had therefore brought down the entire financial system.

All the favourite lines were then trotted out. A fictional journalist from The Times newspaper even portentously described derivatives as “financial weapons of mass destruction” (perhaps it was good that he didn’t bother to name-check Warren Buffett on that one).

Let’s look at the reality. Markets have moved on since the last (and only) time derivatives have posed a real threat to global finance – the fall-out from the collapse of Long-Term Capital Management (LTCM).

Of course, some people consider that the proliferation of hedge funds since then creates even greater potential for chaos to sweep through the financial system.

But let those of us in the industry consider the opinions of Bill Winters, co-head of investment banking at JP Morgan and winner of Risk’s lifetime achievement award in 2005 (see page 18).

In the case of LTCM, Winters says, traders were only interested in survival and failed to spot opportunities the market presented. Now, with skill sets much greater, these opportunities will be spotted, and hedge fund (and other) capital will move in to the market, which will then begin to correct itself, preventing an LTCM-style systemic event. This is, in effect, what happened during the severe dislocation in the US dollar interest rate market in August 2003, which had initially been caused by hedge funds exiting their positions en masse.

Congratulations to all the winners of Risk’s awards. Each has had a year to be proud of, in an industry we should not be afraid to be proud of.