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Book Review: Good Derivatives

RICHARD L SANDOR - Good Derivatives“Water is the next frontier” – Richard L. Sandor 

Good Derivatives: A Story of Financial and Environmental Innovation, by Richard L. Sandor, is published by John Wiley & Sons, Inc. (2012)

by Anne McIvor

Richard Sandor is an unsung hero of innovation. As he points out himself, like Luca Pacioli (‘father of accounting’ and inventor of double entry bookkeeping), he won’t become a household name like Henry Ford or Steve Jobs. But Sandor played a key role in the ‘invention’ of financial derivatives – an innovation which has transformed the financial services industry.

Sandor has been described as the ’father of financial futures’ for his pioneering role in developing the first interest rate futures contract in the 1970s when he served as chief economist and vice president of the Chicago Board of Trade (CBOT). Since the first soy bean futures traded in 1970, annual volumes of derivatives traded have grown by an average of 18% – a rate surpassed only by computer chips over the same period.

Despite this growth, the positive role played by derivatives in economic growth is not fully appreciated. Sandor notes that even “sophisticated observers” such as Federal Reserve Bank Chairman Paul Volker have failed to acknowledge the role of this financial innovation in economic growth. Indeed, derivatives have powerful enemies – he cites Nobel economist Joseph Stiglitz who claimed that there is no such thing as a “good” complex derivative.

Sandor has recently published “Good Derivatives: A Story of Financial and Environmental Innovation”. Although the founder of the Chicago Climate Exchange (CCX), the world’s first exchange to facilitate the reduction and trading of all six greenhouse gases, his definition of a “good derivative” is not based solely on environmental credentials. Rather a ”good derivative” must: 1. be regulated on an exchange; 2. be transparent and centrally cleared; 3. perform an economic function of risk transfer.

Sandor says “speculation is very important” – but emphasises the core difference between gambling and speculation: in speculation, the risk already exists – unlike a casino it’s not a ‘purpose built’ risk. The question is who bears that risk – and Sandor argues that speculation can perform a real social function (for example, through the build-up of speculative stocks of food which can then be released in times of famine).

Sandor points out that the interest rate risk, which caused the US savings and loans bank crisis in the 1980s, has disappeared as a cause of bank problems since the launch of interest rate derivatives. He emphasises that in the 2007-2008 financial crisis not a single bank failure was due to interest rate derivatives. There are some 400 trillion ‘good derivatives’ traded annually and none, he says, caused any problems in 2007 – or since.

The 2007-2008 crisis was down to ‘bad derivatives’, which Sandor defines as: 1. opaque; 2. not centrally cleared; 3. unregulated. He points in particular to the Credit Default Swap or CDS market: CDS derivatives were not subject to regulation and, although attempting to tap into a need for ‘insurance’, they were never formally described by their issuers as insurance – so avoided regulation. 

Sandor reflects on the success of the SOx cap and trade scheme in the US in the 1980s, which dealt successfully with the challenge of acid rain from coal-fired power stations.

Sandor’s conviction about the potential of financial innovation to contribute to solving environmental problems such as SOx or CO2 emissions is inspiring. In answer to those who claim that carbon is a different entity from hard commodities like corn or copper, he acknowledges that there are many issues surrounding proper implementation and that inevitably market participants will abuse models such as the ETS (Emissions Trading Scheme). However, he emphasises that inventors – whether of flying machines or financial innovations – often satisfy a latent demand, and that if we take no risks there can be no innovation. (The Wright Brothers, who flew planes with no safety belts and no night lights, would be outlawed today.)

“Perfect is the enemy of good”, Sandor points out: if we take no risks we can make no progress – but he advocates risk-taking under full government regulation with full transparency. A declining cap succeeded in the SOx market and Sandor believes it has the potential to work for carbon. In environmental markets, he says, the job of the financial innovator is “to put yourself out of business” by eliminating the emissions through an ever decreasing cap. 

Sandor believes that carbon markets have been a major force for good throughout the world, whatever the verdict of the success of Kyoto or the concept of a global carbon market. He points to the fact that there are a host of pilot carbon trading programmes being introduced throughout China and in Korea, Vietnam and Brazil and emphasises that ’cap and trade is very much alive – that carbon has joined the ranks of the other ‘good derivatives’ such as copper, corn, foreign exchange and interest rates.

Water: the next frontier

Sandor believes that water pricing will be inevitable in the future and that trading in water rights will be a natural progression. As he points out, only North and South America and Europe are ‘long ‘in water – India, Arica and China are all ‘short’.

The pricing of water must be considered, he argues: not the kind of water needed to live on (a person needs 20-30 gallons per capita for hygiene and hydration), but a two hour recreational shower, building a golf course in the desert or planting Kentucky blue grass in Arizona, he says, should be paid for. For this financial innovator, “water is the next frontier”. And pricing water will be part of that frontier.

Richard Sandor was the founder and former Chairman and Chief Executive of the Chicago Climate Exchange, Inc. (CCX), an environmental commodity trading exchange; former Chairman and Chief Executive Officer of the Chicago Climate Futures Exchange (CCFE), an environmental derivatives trading exchange; and former Chairman of Climate Exchange PLC, the parent of CCX and CCFE (2003-2010).


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