Copyright © 2004 Norman R. Solberg
Who invented
financial derivatives?
Some
authorities view derivatives as the most significant financial development of
the 20th Century. Many people contributed to this complex and
enormously successful range of financial products. However, the key moment
seems to have been in a London conference room in the mid-1970Õs, when four
American and British lawyers took the vital steps that led to a multi-trillion
dollar industry.
What are
financial derivatives? In simple terms, they are a kind of investment created
by contract, which is based upon some asset, but is not a direct form of
ownership of that asset. In other words, its value is ÒderivedÓ from the asset.
One example is a call option to buy shares. Purchase of a derivative can create
a different risk-reward relationship from that of the underlying asset or group
of assets.
Some writers
attribute the creation of derivatives to three economists who developed the Black-Scholes-Merton
mathematical formula in 1973. That formula, in very simple terms, allowed
calculation of current market value (and apparently the level of risk) of an
asset, such as shares of stock, and of options to buy that same asset. This was
seen as a major breakthrough for traders and investors, who could presumably
evaluate risk and make counter-investments to hedge against that risk. Indeed,
this formula was so impressive that Merton and Scholes received a Nobel Prize
in 1997, Black having previously died.
Nonetheless,
the formula alone did not create derivatives. It took actual financial
transactions to do that, and in fact the purpose had nothing to do with any
pricing formula.
Other persons
think that the options exchanges in Chicago or the similar trading there of
futures contracts in corn and other agricultural products were the origins of
present-day derivatives. In part, they were, but stock options have existed for
years without creating such a gigantic industry. Other forms of derivatives have
existed for generations. The earliest on record are rice future contracts in
Osaka in the Edo Period.
As of 2003,
the global market for derivatives traded outside exchanges had grown to U.S.
$170 trillion, more than five times as big as the worldÕs GDP in 2002.
Obviously, something happened beyond the existence of options and futures to
focus the attention of the financial community on a new product.
In the
mid-1970Õs, I was a young lawyer working for Monsanto Company in St. Louis,
Missouri. It was an exciting job for me. In those days, American lawyers in
private firms often looked down on lawyers in company law departments, but the
quality of the professionals in a company like Monsanto was superb. Several of
its lawyers (including me) later became chief legal officers or General
Counsels of other big companies, one is now the highest revenue-producing
partner in a major international law firm, another became United States
Attorney (the chief federal prosecutor)
in Atlanta and recently Deputy Attorney General of the United States and yet
another currently serves as a Justice of the Supreme Court of the United
States.
Because I had
already done Òparallel loanÓ agreements and an issue of Eurodollar debentures,
when Monsanto developed a need for additional loan financing in Europe, I was
ready to handle this.
In very
simple terms, a Òparallel loanÓ package was a financing technique, principally
used by American and British companies, to meet mutual needs for money in other
countries. Under this technique, an American company would lend U.S. dollars in
the United States to a British company. The British company simultaneously lent
an equal amount in pounds sterling in England to the American company.
Why did they
bother to do this? Under United Kingdom exchange control laws, one could not
easily remit large sums of money in and out of the country. Even parallel loan
transactions required permission in each case from the Bank of England under
the Exchange Control Act of 1947. It was also a means of insuring against
changes in exchange rates.
All borrowing
involves risks, but with very large amounts of money, the risks must be
analyzed with care. We reviewed several types. For example, there is political
risk, in that government policy may change or that some other event may
jeopardize the ability to receive the principal and interest. There is exchange
risk, since values of the respective currencies may vary. Moreover, there is
party or credit risk – in that a party might default.
Because the
loans to each company were for equal amounts, the financial aspects of these
deals were pretty straightforward. Once the amounts and rates were fixed, much
of the work in completing a deal was turned over to the lawyers.
We did
several of these loans. I was regularly flying to London for the negotiations,
and I developed confidence in Francis Neate, a London solicitor, whom I used as
local counsel. Generally, we did these deals together with the other companyÕs
inside and outside lawyers.
As the deals
continued, a very troublesome issue arose. Companies do business in other
countries through subsidiaries – separate legal entities. For example,
Monsanto Company itself could lend the U.S. dollars in the United States to the
other party, but it would be receiving the pounds sterling through its British
subsidiary, Monsanto Limited, which was the entity that would put those pounds
to use. The other party would also have two separate entities lending the
pounds and borrowing the dollars.
This could
possibly create a disaster in the event of insolvency of one of the parties.
Francis started examining what might happen if one of those companies got into
financial trouble. The answer – to the extent there was any answer
– was found in old British legal decisions regarding the ÒbankerÕs right
of set-off.Ó Set-off is a matter that rarely appears in court, but during the
economic depression of the 1930Õs, it became quite important. We found to our
horror that our using separate legal entities meant there would most likely be
no right of set-off. If the other party became insolvent and could not pay back
its loan as payments became due, we could be obliged to return the money we had
borrowed from it, without being able to subtract the money it owed us.
Naturally,
this was unacceptable. The purposes of parallel loans were to avoid risk, move
funds across borders and minimize transaction costs. Francis had raised the
issue, and I had to force it upon the other partyÕs outside lawyer in the
pending deal. Fortunately, we were dealing with John Carroll, an extremely able
lawyer, who ignited the spark that we finally adopted. He immediately
acknowledged the problem, and started toying with ways to eliminate the risk.
If, for example, the principal amounts exchanged were not loans and did not
have to be returned, the risk could be divided. Why not simply write an
agreement to adjust payments to maintain currency rates, or to swap interest
rates? At the end of the term, or periodically during the term, adjustments
could be made and payments settled. Each party could maintain the value of its
principal in its own currency, and differences would be handled through these
adjustments.
The agreement
we wrote became known as the currency swap. The rest is history. The concept
was adopted by the investment banking community with great enthusiasm. A new
product – and a new industry – was born.
A few years
later, Francis wrote to me reminding me that this new industry all started in
that conference room. He had made a great success of his part in it, and later
he wrote a book on the bankerÕs right of set-off. Who then created derivatives?
To my surprise, we did.
Used with the
Black-Scholes-Merton formula for calculating risk,
which had been created for Òplain vanillaÓ options, the concept of derivatives
multiplied and divided into an exotic range of products, far beyond our
original intentions. It is exciting to realize that so many people have built
on our original work.
If properly
used within limits a financial derivative instrument is an invaluable risk
management tool. However, we were very much aware that we had not eliminated
all risks, and indeed we had created the opportunity for new ones.
Indeed,
Professors Merton and Scholes themselves seemed to have been carried away by
the apparent ability to hedge against risks, not appreciating that market
dynamics could change and that not all risks are purely financial. They took
key roles in an investment company called Long-Term Capital Management, which
traded heavily in a wide variety of derivatives. Two years after their 1997
Nobel Prize, LTCM was in danger of collapse, with an imminent threat of default
on $100 billion of derivatives, and had to be bailed out by government
intervention.
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