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

Continued from the previous article………………..

In 1993, long before the world was obsessed with credit derivatives, correlation trading and problem of correlated defaults, Charles S. Sanford, the legendary Chairman of Bankers Trust gave luncheon address at the Federal Reserve Bank of Kansas City's symposium on "Changing Capital Markets: Implications for Monetary Policy." In a seminal paper titled “Financial Markets in 2020”, submitted at that symposium and that formed the part of his speech, he looked out at the financial and banking landscape decades from then. It vision of a future that was so different from what was around then that very few actually appreciated what he had to say.

Here was a man who was saying that in the not too distant future – perhaps much earlier than the year 2020 – economic agents, investors and financial institutions would no longer look at the conventional financial products, such as loans, borrowings, stocks, etc. in static, aggregated terms; but rather all financial products would be broken down into constituent, smaller parts and parceled as “risk units”*. They would be nothing but contingent claims and treated as such. These risk units, the “smallest constituent exposure”** of any financial asset or product, could be parceled in many different ways and would become tradable in the market.

Sanford was suggesting that in the next two decades finance would see a revolution like the one witnessed by physics at the turn of twentieth century. Something like Quantum Mechanics would be born in the world of finance to replace, or supplement, the “Newtonian” world of classical finance. He went further and said that this revolution would also see the marriage of this “quantum finance” with something live evolutionary biology to give rise to a completely different set of analytical framework for practitioners and academics.

He was ushering in the age of “particle finance”. This was the second phase of the financial markets’ evolution and Sanford’s seminal speech was heralding it; but perhaps he, like the organization he led, Bankers Trust, was too far ahead of his time. A full blown credit derivatives boom was still some years away. Within another six years of this speech Bankers Trust was gone. And so was lost the epochal message that Charles Sanford was trying to tell us. It was at best prophecy something that could go well in history books. The world, at least the world in and around Wall Street and the City of London, was too busy battling with interest rates and trying to better the classical world of Newtonian finance, all with the very modest aim of making money, and more money.

And as we now know, this world would soon fall apart, its edifice torn asunder under the impact of various financial crises, such as the Asian financial crisis, the LTCM debacle, the Russian debt crisis and what have you. The Newtonian world, in the words of a City banker, was undergoing a “phase shift” and moving “out of equilibrium”. For an outsider, completely unfamiliar with macroeconomics and theory of finance, it would become practically impossible to separate the cause from the effect. Did the Thai Baht and other Asian currencies get devalued because of monetary imbalance or were the monetary imbalances in the Asian economies got triggered due to currency devaluation? Was the Black-Scholes-Merton model and other physics like models responsible for the mis-pricing of LTCM’s trades or was it the other way round, i.e. LTCM’s trading strategies causing market turmoil and volatility and correlation skew that ultimately rendered the models ineffectual.

For the first time, the economists, perhaps more than the traders or investors, both within the academia as well as in the industry felt completely impotent.

They needn’t have. In 1992, a year before the Sanford speech, George Soros and Stanley Drukenmiller (of Quantum Fund) had shown how spurious the concept of “economic equilibrium” was. While breaking the back of the Bank of England, and pocketing around a billion dollars, they had made a direct assault on one of the most cherished concepts of economics and finance, the concept of equilibrium; the concept around which two of the great theories of finance are developed, the Black-Scholes option pricing model and the Capital Asset Pricing Model (CAPM).

And even though he may not have been aware of quantum mechanics in physics, he likened the situation something akin to what is sometimes seen in the sub-atomic world, the phenomenon of “reverse causality” – the cause becomes the effect. In more ways than one, and with most participants completely ignorant of it, the final years of the nineteen nineties was bringing this classical Newtonian world of finance to an end. The millennium would usher in the new world of Particle finance (or Quantum finance, if you will). Much in advance of the year 2020, Charles Sanford was being vindicated.

The horizon was lighting up. In 1997, an investment banker named David Li at the Canadian Imperial Bank of Commerce in New York was faced with a unique problem. He saw that the traders on the bank’s trading floor who were selling collateralized debt obligations (CDOs), a kind of credit derivative, had no idea how to price default correlations amongst the companies in a particular pool. CDOs had been invented and structured and it appeared to be a great investment tool. Why invest in the bonds of one company and take a big default risk for a fixed yield? Why not invest in a pool of bonds of 100 companies and take a smaller default risk and better the yield? Why should the default risk be smaller in a pool of 100 bonds? That is because, so went the reasoning, not all companies in a pool will default at the same time.

A key problem remained though. If all companies would not default at the same time, then what would be the pattern of their defaults? How will the default of one company in a pool affect the possibility of default of other companies? Traders had no clue. This is where David Li made a landmark contribution; landmark, in more ways that one could imagine. He was literally opening a pandora’s box, trying to get a handle on one of the most intractable of problems in financial markets, the problem of correlation. In the year 2000, inspired by the actuarial problem of “broken hearts” he was the first to come up with a model that tried to explain the joint (combined) default patterns amongst companies in a CDO pool. The famous, or infamous, depending on which way you looked at it, Gaussian copual model was born.

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

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