I went along to a GARP event on Monday night, held at the Harmonie Club in NYC. The event was introduced by Stefan Magnusson, chapter co-director of GARP and MD Market Risk Americas at Rabobank. Jeremy Josse was the main speaker, doing a talk entitled “Value, Financial Innovation and Regulation” loosely based around his book “Dinosaur Derivatives and Other Trades“.
Jeremy started by a quick introduction to himself, describing how he has worked for many financial institutions during his career, but his educational background also included philosophy and economics too. He suggested that much of risk management was about the math and the technical aspects of risk management, whereas he was going to focus more on meaning rather than the underlying detail. Like many an Englishman (!) he almost seemed apologetic for suggesting this but to bare with him as he pulled various strands of thought together.
Starting with Dinosaur Derivatives, Jeremy wondered whether there could be value today in a derivatives contract or option to buy a Megalodon. Given that a Megalodon is an extinct species of giant shark, you would think not given that physical delivery might be a problem. That said, Jeremy thinks there could be a market in such an option due to:
- Brokers – generating demand
- Control of supply
- Liquidity – some illiquid assets trade at a 30% premium to illiquid ones
- Arbitrage – based on some expectation of selling at a higher price
Jeremy then listed off some other assets and considered their value:
- Gold – no utility in this asset glass, reputed as a “safe-haven” asset
- Diamonds – again no fundamental utility
- $ – a fiat currency built on “trust” with no underlying asset, with fiat currencies being used first in China around 1000 years ago
- Contracts for Difference – again no intrinsic value to this asset class
- Internet/Social Media stocks – Jeremy thinks we are in internet bubble 2.0 with group think leading valuations astray
Looking at the Theory of Valuation then the comparison of market value versus intrinsic value is really analogous to technical analysis (charting/trending) versus fundamental analysis (balance sheet etc). Jeremy mentioned the Efficient Market Hypothesis (EMH) and said that anyone that has worked in the markets knows that EMH is not adhered to in the real world i.e. assets do not always reflect all information known about them. In particular Jeremy sees the work of Scheleifer and Shiller in behavioral finance as one of the most interesting areas of financial theory to work in, with the potential to quantify “irrationality”. Jeremy put forward the following three choices that an individual could choose in terms of what money they would receive and what money another individual might receive:
- $100 (me) and $0 (you) – some choose this but not all; we are not all greedy
- $80 (me) and $80 (you) – most choose this but not all; we are not profit maximizers
- $0 (me) and $150 (you) – a few choose this but not all; we are not all generous
Moving on to the Credit Crisis, Jeremy said that this was caused due to the mispricing of assets such as CDOs/CLOs and CDS. This mispricing was caused by complexity and a lack of transparency but such characteristics are fundamental to the nature of financial innovation. As an aside, Jeremy mentioned that smaller regional banks tend to trade at higher multiples than say universal banks due to investor perceptions of greater transparency of what is going on and what the risks are.
So moving on to Financial Innovation, Jeremy asked firstly what a financial instrument is?:
- Rights – to future cashflows etc
- Contractual strings/permutations – choice but leading to complexity
- Epicycles upon epicycles – derivatives but more general dependencies and links
- Some form of legal fiction – to arbitrage regulation and prohibitions
Jeremy talking around prohibition (aka modern regulation) being a driver of innovation, starting in history with the prohibition of usury leading financial innovation to find ways of replicating the returns of interest payments but without there being interest payments, so maybe leasing or buying goods receivable at discounts. Looking at the timeline of financial products through history:
- Loans – available in Babylonian times
- Stocks – available in Roman times
- Convertibles – developed as a form of finance for the creation of the US railroads in the 19th C
- Derivatives – back to Babylon again with property options
- Securitizations – late ’90s
- CDS – late ’90s
Considering the Logic of Financial Innovation, Jeremy said that most professional disciplines used either Empirical Testing or Deductive Inference to innovate and check that something “worked” as such. But really there is no “social laboratory” for financial innovation or indeed for the regulation intended to control/shape it, so most things, including additionally macro economic policy, were implemented without prior testing. Jeremy said that financial innovation is both critical to our economies but also very vulnerable due to this lack of testing.
Back to the Credit Crisis, Jeremy said that 10 years running up to the crisis were the social laboratory for CDO/CLO/CDS products but these were mispriced due to a lack of testing. This was a major cause of the crisis but such innovation (and lack of testing) is fundamental to the nature of financial innovation itself. Coming forward to today, securitization is now better understood, biases by rating agencies have been controlled and counterparty risk is being reduced through clearing. So put another way, financial innovation has a stormy creative period where a new product morphs and evolves and pushes the limits of what people, corporations and governments find attract or acceptable, until these limits are pushed too far and a crisis ensues – then finally maturity comes with experience and better understanding of the risks.
Jeremy is a collector of Antique Maps, which he says have become an interesting asset class and listed their history:
- 1970s – emerged as a new asset class
- Asset subject to wild price movements/patterns of behavior
- Now an established art form
Initially dealers would visit libraries containing maps (notably Harvard in the US) and simply rip out pages from it. The market had misrepresentations of authenticity (lying), theft, short-selling, insider trading and many other dubious practices. This initial period of innovation was very destructive without regulation, but now antique maps are an established art form and asset class. So there is a real dichotomy between this destruction that eventually led to people seeing ancient maps as things of beauty, collecting them and hanging them on their wall.
So why are Regulations needed? Jeremy said that regulation was needed to control:
- Dysfunctional patterns of behavior
- Extreme value fluctuations – primarily due to greed
- Wealth distribution – implementing social justice
- Financial innovation
But what is the Right Kind of Regulation? Jeremy said that we should not hand over “The rule of law to the rule of lawyers”. He said there had been 100 years of regulation, with a lot of focus (particularly in the US) on rules that micro-manager what institutions can and cannot do, built up on closing the door after each fraud/incident. Here he talked of Dodd-Frank with all of its detail but particularly gave time to say he thought that the “Living Wills’ regulation was a work of fiction and of little practical use – he quoted Hemingway who said that “You go bankrupt slowly then quickly”.
Jeremy believes that Principles-Based Regulation is a better solution – although I would say that this proved no better looking at the UK vs US regulation through the crisis? He advocates taking politicians out of the rule making, with judges making decisions based upon case law as it builds up over history. The issue of enforcement seems to loom large here, even if principles could work, they will not work with enforcement. Jeremy pulled up a diagram showing arrows between Value, Financial Innovation and Regulation showing how intertwined they were. He suggested that “vexatious” litigation (the contract must cover every eventuality) was a problem in US regulation in particular. More fundamentally, creating regulation prior to knowing its effects was extremely difficult, since society and economies are not bounded games, unlike chess say where a computer can evaluate all possibilities.
There were some audience questions, firstly on the viability of bitcoin which Jeremy was negative on, saying that without trust, value can disappear and that “our” electronic money only works because it is backed by governments. Another question talked about the SIFIs and Jeremy said he favored breaking them up over more regulation to control them.
In summary, Jeremy was a great speaker with some good ideas. As he said, most were common sense but I guess his main point was that financial innovation would not happen if it is regulated too quickly/too harshly. So new financial innovation can be destructive and painful, but regulation itself can stifle innovation and the creation of value and new markets.