Merton H. Miller is the Robert R. McCormick Distinguished Service Professor of Finance Emeritus at the Graduate School of Business at the University of Chicago. One of the most distinguished academics in the field of finance, he was awarded the Nobel Prize in Economic Science in 1990 for his work in the area of corporate finance.

Miller has written widely on a range of topics, and, with Franco Modigliani of MIT, he developed the frequently cited "M&M Theorems" that are foundations of the theory of corporate finance. He is the author of Macroeconomics: A Neoclassical Introduction (1974), The Theory of Finance (1972) and, most recently, Financial Innovations and Market Volatility.

He is also one of the most outspoken critics of proposed government interference in the financial industry, and has ardently defended the use of derivatives instruments.

This interview was conducted in June by managing editor Simon Boughey.

Derivatives Strategy: What was your reaction to the Procter & Gamble/Bankers Trust decision and the comments that were made by Judge Feikens?

Merton Miller: I think some of the judge's comments about whether swap dealers are fiduciaries are very helpful to the swaps industry. If he had decided that swap dealers have special fiduciary responsibilities when dealing with sophisticated commercial clients, it would have been a very unfortunate result.

DS: Is it as significant a decision as some people have suggested?

MM: It could very well be because before these rulings there was a significant body of opinion that thought that Bankers Trust was likely to get hit with a lot of adverse rulings. So I think the principle of, "We are dealing with people that know what they are doing," is important. There is another aspect that I think is worth mentioning: if dealers lose these cases, the cost that they bear is going to be built into the fees they charge to clients. So if their competitive position is weakened by making them more vulnerable to suits, end-users are just going to pay higher commissions.

DS: Is the derivatives industry healthier than it was a couple of years ago?

MM: I think so. A year and a half ago, everybody was ready to write the industry off for dead. There was a scandal a week. Volume was drying up. Even then I tried to argue, not always successfully, that it was not really as bad as it looked. If you broke it down, some derivatives areas were increasing in volume. That was true of exchange-traded products. The equity products were doing fine. The interest rate products and FX products were not doing well, but that is understandable because the volatility was down. Central banks-and I am not among their greatest admirers-somehow seemed to have put the inflation genie back in its bottle. Everything ultimately depends on inflation, and as long as that is dying down, there has to be a decrease in volume. Derivatives are designed to hedge risks. The less risk there is, the less demand there will be for hedging.

DS: You are on record as saying that the social costs of derivatives debacles has been negligible. Can you expand on that?

MM: Derivatives horrors mostly turn out to be just wealth transfers between counterparties. You have to remember that any derivatives position always has two sides-a long and a short. At all times these positions cancel. Thus the gains and losses incurred represent what economists call a transfer of wealth, not a change in aggregate wealth. They must be distinguished from an earthquake, which involves actual destruction of aggregate social wealth. In the P&G case, for every dollar that P&G lost, Bankers Trust made a dollar, and as P&G stock fell BT stock rose. It is slightly less easy to see this in the Orange County case, but the counterparties, which sold the inverse floaters and the reverse repos to it, gained. And these were government-financed agencies like Fannie Mae and the U.S. Treasury itself. So the wealth transfer was from the taxpayers of Orange County to the general body of U.S. taxpayers.

DS: Did any of the derivatives crises indicate to you that there are certain instruments that are dangerous, or were they all really just massive failures of control?

MM: They are almost entirely management problems. In some cases management understood, but was not able to explain what it was doing. I do not think that the derivatives themselves have been responsible. Some derivatives I've seen, like those in P&G and Gibson Greetings, were really weird structured notes, but demand for these products is dying down. I do not think that there is as big a volume as even a few years ago. That is good; it shows that the market is learning finally and realizing that these things probably do not make a lot of sense to people.

DS: Do end-users take any responsibility for the derivatives crises?

MM: End-users are mainly responsible for many of the unpleasant events that have occurred, because they did not do what they would do in even the most elementary, non-derivatives arena. If you do not know yourself, you do not automatically take the dealers' word for it. You either consult other people or shop around. If you were buying a used car, you would want to look around a little and maybe have a mechanic look it over before you put a lot of money into it. It was bad management. Somehow they neglected the elementary precautions they would take with any other area.

DS: How do derivatives fit in with classic economic theory about the way the market operates?

MM: Once you consider them simply as devices that are trading in markets, then standard economics applies. There are two reasons to use derivatives. One is that it is cheaper to trade in the derivatives than in the underlyings-the classic example being an equity index product. With one snap of the fingers, you can trade 500 stocks at a very low cost. The other is that derivatives make it possible to deal with volatility, which is a whole new dimension and one that is very hard to access with ordinary securities. With options you can actually take positions on the amount of uncertainty in the markets. So in that sense, the derivatives do help to complete the markets and do add to the efficiency of the financial sector.

DS: Does economic theory have anything to say about the way the derivatives market will develop?

MM: Yes, it does. Let's take an analogy. If I want to go between New York and Chicago, I have a variety of ways of doing it. I could go by bus, by car, by train, by plane and, to some extent, by boat. So there is a variety of competing ways to get the job done and demand and supply will be at work. You know that there are some people who do not want to take the risks of flying. There are also some people who have more money than they have time, so they are willing to pay a premium to go by air. And there are some people who have more time than money and are willing to go by bus. And similarly in any field of endeavor, including the derivatives markets, people have different investment objectives and they sort out for themselves appropriate markets. So some will use the exchanges, some would use the OTC market. It is a question of size: if you are a big bank, you are likely to want to make your transactions on a counterparty-to-counterparty basis; if you are a little less big, you may want to use the exchanges because the credit risk problem is handled in a cheaper way for you through the clearinghouse.

DS: Do you see interest rate swaps becoming more like exchange-traded futures?

MM: They probably would be now if it were not for the Commodity Exchange Act. If left to their own devices, the OTC market-makers would have adapted a lot of tools that the exchanges have used, like standardization. But they would run into the CFTC, who would say they are doing illegal off-exchange futures. The CFTC is a major obstacle that the industry has to learn to live with, but it does have the benefit that it probably keep some competitors at bay.

DS: Is the understanding of derivatives improving in the U.S.?

MM: Yes. It improves with every class that we graduate from business schools. I sympathize with these elderly corporate executives who are faced with another revolution. The young kids coming up today will look back 30 years from now and say, "Do you realize that in 1996, most corporate honchos did not know the difference between an option and a future?" and everybody will laugh and say, "You're kidding." It is a generational problem; this stuff is too new and too specialized to be fully absorbed yet by the current generations. But it is improving. For one thing the older generation gradually retires and gets replaced with younger people, and also more firms are conscious now of the need to get everybody on board. More companies now are conscious of the need to have a central policy and to look at what it is they are doing and why.

DS: So the work of G-30 and successive reports, emphasizing the need for management control, have done a great deal of good?

MM: They may even have gone too far in the sense that they have activated FASB and the SEC, who of course apply the standard "one size fits all" remedies with unfortunate effects. But these remedies have not gone through yet and we will see what happens to them.

DS: Do you think that FASB will be deterred from that "one size fits all" approach to hedging and hedge accounting?

MM: FASB board members were appointed to come up with rules and, by God, they are going to come up with rules. Whether the rules make any sense or not is beside the point! However, the idea that these things should be subjected to cost­benefit analysis is finally beginning to dawn in Washington. You do not just sit down, take a blank sheet of paper and write up some rules. You have to ask whether the benefits are worth the huge costs that we are imposing on people.

DS: Given your views on some of the central banks, were you pleasantly surprised by the defense of derivatives that most of them made during the great debates of 1994?

MM: I am pleased because I think that they recognize-and it is obvious to anybody who studied these matters-that derivatives made things safer, not riskier. They have enabled the banks to protect their asset liability structure much more easily and to diversify better than they could before. There are a few central bankers and regulators who think that anything that causes them trouble, even potential trouble, has to be wrong. They are in a difficult position because they do not benefit directly when things are going well, but they take the blame when they aren't. Under those conditions, there is a terrible tendency on the part of some of them to say, "Look since I only get hurt on the downside, let me make sure that it does not ever happen."

DS: So you fear that they support the politicians who were predicting a repeat of the thrift crisis?

MM: The treacherous thing about the world is the same thing does not happen twice. We will not get another thrift crisis. We will get some other kind of crisis. However, having brought inflation under control the likelihood of these disasters is now very much reduced.

DS: Now that we are seeing a compression of revenues in the derivatives business, what is the next step for the business?

MM: The laws of economics apply here as in any other industry. If volume is down, there will be a shakeout and firms are going to leave the industry. We thought heady growth rates could be extrapolated out to infinity, but this doesn't happen in the computer industry, in the auto industry or in the derivatives industry. For many years, those big European banks were laughing at American banks, saying they have been driven to generate fee income because their regular banking business is drying up. But then somebody in Europe did some sharp pencil work and realized that there is a lot of money in derivatives. So European banks with their big capital bases entered the business, and every deal that Swiss Bank does means one less deal for Chase.

DS: Given that fact of the general compression of profits, have banks like CIBC or Deutsche Morgan Grenfell chosen the wrong time to invest as heavily in derivatives as they have?

MM: Probably. The industry is probably due to contract because the volatility is down and volatility is what the industry lives on. I do not know who the survivors will be. Deutsche Bank has got a huge capital base which is a big asset in this industry where credit is so important.

DS: Not all the triple-A derivatives products companies that were formed over the past five years have been profitable. Did the firms that formed them make a mistake?

MM: In part they ignored what some people call the M&M (Miller & Modigliani) theorems. If you allocate capital to a subsidiary you raise its credit rating, but you are taking capital from somewhere else. I am a skeptic from the old school, saying you cannot increase the size of the pie by cutting it up into more pieces.

DS: Are they any products that are likely to be developed in the next few years?

MM: I work closely with the Chicago Mercantile Exchange. Bringing out a new product takes six months as we to have to get it through the CFTC, whereas an OTC person or a London futures exchange can bring it out in a day or two. That is one of the curses of the CFTC regulation. But I think that there are important product areas that are beginning to emerge from the fog. Insurance futures is a market where I think that derivatives can make a big impact. Also, electricity is an industry that is about to be deregulated; it lends itself beautifully to this kind of trading.

DS: How popular are courses on derivatives at business school?

MM: We cannot get enough courses on them. You know, the field has exploded so that we keep giving courses in financial engineering, futures and options. MIT, Stanford, NYU, all of the big schools have presence in this area. Like any other industry we are demand driven. If that is what the customers want, that is what we are going to give them.

DS: What structures are people most keen to put together at the moment?

MM: The holy grail, which everybody is looking for but nobody has found, is a nice term structure that can be used for interest rate derivatives. There are kind of simple ones, incorporating one factor or two factors, but they get loose around the edges. When you are pricing things, 90 percent to the answer is not quite good enough. So there is a lot of work being done on interest rate stochastic processes and models of interest rates. There has been a lot of interest in complex options, with two indexes and look-backs and knock-outs, although I am not sure that that is where the future lies. But interest rates are going to be around for a while.

DS: Is the industry now free from fears of legislation?

MM: Yes, because the industry is diverse enough so that any legislation that is proposed looks like it is going to help one group and hurt another. Politicians cannot agree what to do, they like to talk and like to show that they are on top of things, but there is no urgent reform that is on everybody's agenda. And people in the United States, as you know, are very cynical at the moment about what regulation can accomplish anyway.