A serious future...
The number 100 deserves obviously some retrospective. The finance industry has considerably evolved over the last 10 years and 2018 happens also to be the year of the 20th anniversary of FinMetrics. Life is made of cycles and evolutions are not coincidental...so was the creation of our firm when «risk management» exploded with Value-at-Risk (VaR) as the trendy measure at that time.
The 80s saw the development of evolving generations of derivatives, with the first swap originating in 1981, swapping DEM for CHF, between IBM and the World Bank. The 90s saw interest rates going down, thus interest margins shrinking for banks, encouraging them to invest directly, swapping their pure intermediary role with a hybrid one where their business model became much more sensitive to the direction of markets. Finance had benefited a lot from economics and statistics in the past. But now mathematicians and physicists entered the game, building up on the need to master mathematics for the pricing of ever more complex and less tangible underlyings or exposures. What a fabulous ground to implement their techniques! The first ever-recorded collateralized debt obligation (CDO) appears in 1987, credit default swaps (CDS) in 1994, double-barrier options around the end of the 90s, and so forth.
Technology had been evolving in parallel, allowing calculations that were simply unimaginable some years before. TCP/IP and Telnet come to light between 1969 and 1973, and Netscape, the first web browser, arrives only in 1994. Google is founded in 1998. Nvidia, founded in 1993 as a graphics chips company, unveils in 2006 the capacity to use GPUs for grid computing. And today, your iPad runs probably as fast as a Cray 2 of 1985 (CPU-wise)… without the need of pressurized liquid cooling and a heat exchanger the size of a car.
"Finance had benefited a lot from economics and statistics in the past. But now mathematicians and physicists entered the game."
- Hugues Pirotte, Professor of Finance, Solvay BS, ULB
In parallel, crises make their own appearance: the banking crisis in 1973 in UK, the Latin American debt crisis (early 80s), the failure of almost 1/3 of savings & loans in US in the period 1986-95, the Black Monday in 1987, the Swedish and Finnish banking crisis (90s), the Mexican crisis (1994), the Asian crisis (1997), the Russian financial crisis (1998) with the collapse of LTCM, a major hedge-fund founded by some Nobel-prize winners among others and representing a systemic threat, the Argentinian economic crisis (1999-2000), the so-called IT-bubble (2001-2002), the 2007-2009 financial crisis with repercussions until 2011 with a banking liquidity crisis, and cases of rogue trading and rigging, among the main ones.
Surprising is how much some actors were “surprised” by those events. First, risk “management” means that there is some form of action/decision based on awareness, i.e. the identification and quantification of exposures. But, de facto, over the last 20 years, a lot of emphasis has been made on risk reporting. That means pushing reports to all stakeholders on a defined regular basis. Even though some of us have been advocating for more “monitoring” than just reporting, i.e. pulling dynamically information when needed or being averted, we had to wait somehow for the “digitization wave” to hear more about dashboarding, agile programming and ergonomic apps. Still, this is about being aware.
Secondly, decision and action need to rely on a strong body of values, a fluent organization, and known processes. Many of those problems faced by the industry were rooted not in products, nor on bad models, but simply, on bad governance. Not to say the least. Without governance, inertia, overconfidence, greed (not just about money but other types of reward as well) might take the lead. If we couple this with (1) incompetence, and (2) the opacity due to the (desired) complexity of products and strategies, we can obtain a dangerous cocktail. Since the Brady Commission of 1988, many academics have come forward to globally say “don’t blame the knife for the murder”. Derivatives were used by some to take more risks, to disguise them, to create confusion between cash and exposure, to leverage positions. Others used them to mitigate exposures to be allowed to hold bigger positions, too confident on liquidity and forgetting that their model did not integrate human behavior. In front of them, we had naïve managers, who wished “someone knew”, who didn’t remember that there are no free lunches. Huge profits might not come without big risks. And risk not materializing into losses in the past are not a guarantee of no losses in the future, nor a proof that the person actually knows what he is doing. Or worse, it might be a proof he knows it too well. Many bank CEOs had to admit they were ignorant, not to admit they were just hoping to fool others a little bit longer. We had cases of insider trading, “smoothing of performance” between fund classes, structured products with maturities of 14 years sold to 90-year old grandfathers, client portfolios containing bonds and stocks of the same bank that manages them as major positions, bank mergers to cover astronomic derivative losses, agents growing their business certifying CDO2 highly-rated based on the existence of a temporarily highly-rated credit enhancer and managers believing those certifications without examining the tangibility of the structures, bank selling products conditional on getting retrocessions on them…what else?
The result is today a financial profession which has suffered a lot, creativity in derivative structures that went down the drain, clients who do not want to pay for services now they are seen as a commodity, and a substantial amount of regulation that is “form over substance”, which should have probably been designed by banks a long time ago but the latter didn’t move until it was a “must have” imposed by the authorities.
The good news now. Technology, lessons learned, realizing that many financial tasks are actually administrative and can be automated, standardization of protocols and rules will bring a lot of transparency, efficiency and accountability. Of course, flexibility in creativity has suffered. On the other side, financial institutions are maybe now seen for the first time, as any other corporate firm. Let’s hope regulators will also evolve, with smart regulations and smart contracts, where any issuer won’t be allowed to issue prospectuses or new rules, without a public API that allows to value them. Let’s be serious in our profession.