Speciation and Evolution of Financial Markets – I
Team Latte
December 31, 2007

On the eve of this coming New Year, a lot of people are engaged in figuring out where the markets will be at the end of 2008. How will the credit markets unravel and how the equity markets will absorb all that debris coming out of the credit markets. Will the global equity markets continue to rise? Will the volatilities in the equity markets hit bigger highs or will they abate? Will the credit derivatives see greater innovation in the coming year or will they get a step closer to extinction? Will the M&A activities, measures in deal value, increase or decline? Will emerging markets attract a greater portion of investment portfolios than G7 thus maintaining the overall high absolute return for investors? These and numerous other similar questions are dogging the investors and market practitioners this new year.

But all these are momentary thoughts, mere trivia, born out of our fear and greed, and in large measure ignorance. We should be asking bigger and more fundamental questions. We should perhaps be asking how the financial markets would look like in the year 2020. What would be the fate of financial derivatives ten years from now? Will the “equity” – the common share – of a company remain a title of ownership for the holder or it will become nothing but a contingent claim on the assets of the company? Or, as envisioned by Shearson Lehman (predecessor of Lehman Brothers) in 1980s, will equity, the common share of a company, become an unbundled stock unit (USU)?*

Sometimes, since the middle of 1990s, the financial markets entered an evolutionary phase. It was the second phase of development, the first having started with the 1973 publication of the famous paper by Fisher Black and Myron Scholes, and the acceptance of the Markowitz-Sharpe’s mean-variance dictum of portfolio investments close to that period. The peculiar thing about this phase of evolution of the markets was that the process of “speciation” of assets and financial products (the process by which a particular financial asset splits into two or more assets, cash flows or derivative payoffs) was smooth and was not marked by any discontinuous events, the kind that alters one’s world view completely. There was no Black-Scholes paper on option pricing or no 1987 style crash and acceptance of Rubenstein-Leland’s axiomatic portfolio insurance strategies in mainstream finance. Nothing that was earth shaking or that would produce a paradigm shift in our thinking.

True, late nineties saw the Asian financial crisis, the LTCM blow up and the Russian debt crisis. But these did not alter our world view of finance or the financial markets. They were crisis of confidence, which were promptly dealt with by the Central banks and market agents (though not necessarily with a long term view in mind). But they were not the crisis of intellect. Nobody asked, whither finance or whither financial derivatives? Nobody was bothered about questioning the theory and axioms which supported the edifice of quantitative finance and financial derivatives. There was no need to; rather, on the contrary, it was the other way round.

The mid to late nineties saw a tremendous amount of innovation was going on the area of financial derivatives and financial economics. New derivative products and product ideas were coming from the quant desks in Wall Street and the City of London. A lot of research was being carried out in the area of financial econometrics, volatility and correlation modelling and exotic option pricing theories. Even the Universities, notable amongst them the Stern School and the MIT, were in full gear spewing out important research that was being absorbed in the markets immediately. This was the golden age of speciation for financial derivatives. (We have borrowed the word “speciation” from evolutionary biology to signify the birth of new species. Just as in biology, so in finance, speciation would stand to imply birth of new products – derivatives and structured products – out of the old products, such as stocks, bonds, loans, etc.) Financial derivatives became the cornerstone of any large bank’s profit strategy and bottom line (not necessarily as a balance sheet exposure).

And credit derivatives were born. For the first time in the history of money lending, the risk of a borrower going under and not being able to pay back the money to the lender, was no longer insurmountable. That risk could be isolated, packaged and bought and sold as a separate product. All of a sudden, our world seemed ten dimensional and a trillion dollar industry was born.

To be continued in the next article…………………..

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