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Home > Capital Markets Viewpoints > The Problem with Derivatives, Quants, and Risk Management Today

Capital Markets Viewpoints

The Problem with Derivatives, Quants, and Risk Management Today

by Paul Wilmott

Table of contents

Introduction

Paul Wilmott is a financial consultant, specializing in derivatives, risk management and quantitative finance. He has worked with many leading US and European financial institutions. Paul studied mathematics at St Catherine’s College, Oxford, where he also received his DPhil. He founded the Diploma in Mathematical Finance at Oxford University and the journal Applied Mathematical Finance. He is the author of Paul Wilmott Introduces Quantitative Finance (Wiley 2007), Paul Wilmott On Quantitative Finance (Wiley 2006), Frequently Asked Questions in Quantitative Finance (Wiley 2006), and other financial textbooks. He has written over 100 research articles on finance and mathematics. Paul Wilmott was a founding partner of the volatility arbitrage hedge fund Caissa Capital which managed $170million. His responsibilities included forecasting, derivatives pricing, and risk management. Dr Wilmott is the proprietor of www.wilmott.com, the popular quantitative finance community website, the quant magazine Wilmott and is the Course Director for the world’s largest quant education programme the Certificate in Quantitative Finance (www.cqf.com).

The press has recently vilified derivatives and Warren Buffett famously called them “weapons of financial mass destruction.” What’s your feeling?

A decade ago, I wrote about how the derivatives market now exceeded the size of the underlying market. Small quantities of derivatives are fine, but if you look at the derivatives trading on the back of IBM or HBOS shares, the sheer quantity of trading that goes on is both worrying and lethal to the health of the underlying companies as well as the broader economy.

If you can make some money on a small number of derivatives, then people will naturally lever up to make greater returns—and that’s when things get dangerous. Banks have being selling these instruments for years now without worrying about the repercussions. I’m surprised that just because Warren Buffett started talking a few years ago about the danger of derivatives, people started wondering for the first time, “Hang on, can that be right?” It’s staggering how little people think for themselves.

What’s the solution, then, as derivatives seem here to stay, be it for hedging and portfolio efficiency, or for unique different trading strategies? Is the answer greater transparency as some people have called for?

I’m not sure greater transparency would help. Ratings agencies and regulators go into banks all the time to examine their instruments and models.

The problem is that they are all using similar—and poor—risk models, and everyone is doing the same trades in large numbers and sizes. A ratings agency, for example, will walk into one bank and see what trades they’re doing. It will then go into the neighboring bank and see the exact same trades. Realistically, anybody should have immediately seen how dangerously correlated the whole system is.

There is plenty of transparency at the moment where regulators and ratings agencies are seeing this. The problem is that they all still sign off and give the Triple A ratings. For me, there is a distinct moral hazard in the way ratings agencies are compensated: banks and companies pay them millions of dollars to get ratings, which creates a system that is inherently conflicted. When the lawsuits start in a few months’ time, I hope that ratings agencies will suffer the largest damages.

As well as transparency, you need someone to do something about what they see—and that simply isn’t happening today.

What about the regulators, then? Increasingly, there have been calls for greater regulation to solve the problems within the system, such as the nature of compensation.

As far as regulations are concerned, there are two sorts that should come into force.

The first is diversification. You have to diversify and spread your risk amongst a range of instruments that are as uncorrelated as possible—that reduces risk. However, this will be very hard to implement, and an alternative might be to instead target limits on the large quantities that banks can otherwise trade in a small pool of derivatives.

The other issue is compensation—and that can be regulated. We have got to stop compensating people for taking ridiculous risks with other people’s money, and this could be implemented in a day if politicians really wanted to.

There are lots of ways to do this. Link the compensation to the maturity of the instrument. If a banker is responsible for putting together a five-year CDO (collateralized debt obligation), trickle out their bonus over five years. Then, you have a system similar to the royalties that musicians receive long after they have recorded a song. This also encourages people to trade shorter-term instruments that have greater transparency.

Pay their bonuses in company shares, for example, so that they bear the risk of loss. If you stick with the current status quo, where bankers get paid on the upside annually without any downside risk, then you’re still encouraging them to bet as much of other people’s money as possible, with obvious and now well-known consequences. The compensation needs to be smaller as well. Bankers can’t be paid the vast amounts they’re receiving now for risking other people’s money—it’s just not morally right.

Let’s talk about the instrument that’s been most in the press, credit default swaps (CDS), where the size of the market has become ridiculously large compared to the companies whose defaults they’re underwriting. What do you see as their future?

Nassim Taleb and I have talked out for years now about the size of these markets and how, in some cases, you’re even buying protection on a company from itself, which seems crazy. These risks have always been clear but no one has ever admitted it, as they’ve all been busy making too much money.

To deal with the problem, you can set up an exchange and have standardized contracts. With simple CDS, this can give greater transparency as people can see how many there actually are. But more complicated structures are harder to standardize. While there’s nothing inherently wrong with these, it is essential to see how many are being used for hedging and how many for speculation, as you cannot have more speculation than there are underlying assets. Most should really be used for hedging, such as companies looking to hedge the risk of their suppliers going bust.

Otherwise, you increase the risk of contagion and systemic failure, as no one knows who the ultimate counterparty is. Their sheer size also matters, as it wouldn’t matter if these contracts were traded in small quantities. But the quantities are so large, and everything is continually repackaged and moved from one bank to another, that no one knows anymore how much there actually is out there and, more importantly, how much is still outstanding. You need to see who has what, and who they’re trading with.

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Further reading

Books:

  • Wilmott, Paul. Frequently Asked Questions in Quantitative Finance. Chichester, UK: Wiley, 2006.
  • Wilmott, Paul. Paul Wilmott on Quantitative Finance. 2nd ed. Chichester, UK: Wiley, 2006.
  • Wilmott, Paul. Paul Wilmott Introduces Quantitative Finance. 2nd ed. Chichester, UK: Wiley, 2007.

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