HALL OF FAME
ROUNDTABLE

Hall of Fame honorees talk about market and credit risk, asset management, the euro and strategic alliances between exchanges.

MODERATORS

Joe Kolman, editor, Derivatives Strategy Michael Onak, partner, Arthur Andersen

PARTICIPANTS

Lisa Polsky, managing director, Morgan Stanley Dean Witter Jorg Franke, CEO, Eurex Leo Melamed, chairman emeritus, Chicago Mercantile Exchange

Michael Onak: Lisa, you're now in charge of market and credit risk for all of Morgan Stanley Dean Witter. How are you trying to get your arms around that assignment?

Lisa Polsky: All risks are extremely interrelated. Derivatives people know this well, because derivatives typically embed many risks into one product. When you trade equity derivatives, for example, you have interest rate risk, foreign exchange risk, volatility risk, credit risk and, of course, equity risk. They move dynamically with each other, so you can't unbundle them and give the interest rate risk to the interest rate division and the FX risk to the FX division. They are inextricably intertwined.

And so are the risks that a firm runs. Market risk, credit risk, collateral risk, operating risk, documentation risk—all those risks are intertwined. If you take a silo approach to risk management at the firm level, you run the risk that, by attempting to eliminate one risk category, you pass the risk on to another category. For example, if you “square up” market risk, you incur credit risk; if you use netting and collateral to reduce credit risk, you incur legal risk, documentation risk and operating risk. The bottom line is that you have to take risk to make a return. Not making an adequate return is also a risk. At its core, risk management is about creating the right balance among all the risk categories.

Onak: How does this new challenge differ from your first attempts to use FX options in 1982?

Polsky: When I wrote my first option, there was no ticket for an option—we had never written an option before. There was no back-office processing and no accounting policy. No brochures or marketing materials had been written to explain the benefits, opportunities, costs and risks to customers. I had to think through each of the pieces just to get it off the ground.

As risk manager, I'm now doing the same thing, only it's on a bigger playing field. I'm looking at the interrelationships of the risks that make up our business, and working with the business heads to make sure we're earning an adequate return for all of the risks we take. At its core, this is a balancing act.

If you focus only on one thing and don't have your eyes on all the balls, one of them will sneak up and surprise you.

Joe Kolman: The asset management business has been slow to adopt the risk management technology that the sell side has embraced. Why is that?

Polsky: One of the reasons is that the major risks in asset management at the enterprise level are what we in the derivatives industry call long-tailed risks. They're the hardest to measure and manage. The derivatives business started off measuring the easy stuff—market risk. Then it moved on to credit risk, which was more complicated. But when it got to the areas of franchise risk and operating risk, the risks got much more difficult to evaluate.

“Lisa, how does this new challenge differ from your first attempts to use FX options in 1982?” —Michael Onak

In asset management, the primary concerns are operating risks, compliance and sales practices. But it is clearly important to understand portfolio risks as well—in order to get a concentration perspective across funds and to measure a fund's risk profile relative to its target return, thus ensuring that the fund not only complies with its investment guidelines but also reflects the descriptions given to customers. In the days before financial engineering, when the scope of products available to portfolio managers was more limited, risk management consisted primarily of portfolio analytics, investment guidelines and holding reports. That is no longer adequate. There is, increasingly, a move from investment guidelines to risk guidelines.

Onak: One of your assignments at Bankers Trust was to “reinvent asset management” using various derivatives and risk management methodologies. What's the future of asset management going to look like?

“When I wrote my first option there was no ticket for an option. I had to think through each of the pieces just to get off the ground. Now, as risk manager, I'm doing the same thing, only it's on a bigger playing field.” —Lisa Polsky

Polsky: Derivatives revolutionized finance by unbundling the risks of traditional financial instruments so we could look at each risk silo and the interrelationship of those risk silos. But once they were unbundled, there was also the ability to repackage them to create new products. It saddens me when young people in the derivatives industry today talk about derivatives as products. You ask, “What's the definition of a derivative?” They say options, swaps, caps and so on. That depresses me because derivatives are far more powerful than the products. Derivatives are the ability to create those products.

Once you can create products, you can ask customers, “What is it that you want?” and then create a solution for them. Before derivatives, people used to say, “I have these bonds to sell and these stocks to sell because this issuer has just issued them. That's all I have. Do you want to buy them?”

In asset management, people are still selling product. They're saying, “These are the funds I have to sell. Do you want to buy my funds?” People aren't saying, “What is it that you would like? What are your objectives and goals in investment management?” Take, for example, ideas like principal-protected funds or funds “quantoed” into foreign currency. People have just started to think about these opportunities in asset management. When asset managers unbundle financial risks and combine them with the various types of alpha they can create, they will have a powerful set of tools to create new solutions tailored to their customers' wants and needs. That's what I think the future of asset management will look like—and it's probably not that far away.

“If exchanges are going to compete effectively with [proprietary] trading systems, exchanges should be able to provide the same functionalities and the same cost structure.” —Jorg Franke

Onak: I'd like to turn to Jorg Franke and the exchange world. Jorg, what kind of strategic alliances are we likely to see between exchanges in the future?

Jorg Franke: In my office, I have five fountain pens with ink bottles. It's a memory of the eight letter-of-intent agreements we've signed: three with Matif, one with Simex, two with the Chicago Board of Trade, one with Soffex and one with the Finnish Exchange. Out of these, there were only two final agreements, although I hope there will be a third one in the next few months with Finland. But as a consequence of these two final agreements, there has been only one real merger—the merger of the derivatives markets in Switzerland and in Germany.

It's easy to sign an agreement, but why is it so difficult to work out an agreement? First of all, the exchanges and clearinghouses are even now subject to national pride. Second, most of the exchanges trading electronically have new systems, and none of the exchanges wants to throw its new system away. Every exchange is convinced that its trading system is the best one. Third, the trading and clearing environment at exchanges are all extremely different. Some exchanges have different electronic trading platforms, and some have different clearing systems. Even the cultures are different. Look at the Chicago Mercantile Exchange and the CBOT. Although they're in one town, they still can't reach agreements together. There are also different legal issues to contend with. This is true for bankruptcy laws, for example, and disclosure rules.

On the other hand, the need for more and more global trading facilities is obvious. Global traders are asking for better access—and cheaper access to more than one liquid market. They don't want to pay several times for several different trading platforms, as well as for margining systems, clearinghouses and networks. They don't want to learn different rules and regulations, such as trading hours and so forth.

If this is obvious, then exchanges will have to find ways to link to each other to give people access to different markets. That's what we're trying to do. The failure of the agreement between the CBOT and Eurex made it clear that it's not easy. But we'll have to work on ways to make it easier.

Onak: Cantor Fitzgerald and EBS have recently launched new products designed to compete with services offered by the established derivatives exchanges. Are they a real threat?

Franke: The new chairman of Liffe recently announced that the real challenge in the future will not be competition between exchanges, but competition between exchanges and proprietary trading systems such as EBS or Cantor. I think this is true.

Look at Bloomberg or Reuters or other data providers. They are able to build trading systems that could compete with exchange systems. The exchanges will have to make it clear to market participants why it is worthwhile to use an exchange. They will be able to compete effectively with these trading systems if they can provide the same functionalities and the same cost structure.

Onak: What impact has the euro had so far at your exchange and other European exchanges?

Franke: There were a lot of theories about what would happen when the euro was introduced. One theory was that there would only be one money market within the EMU countries. Now, we have two markets: one based on Libor in London, and one based on Euribor, calculated on the European continent. There has been heavy competition so far, but it seems that Euribor will win.

At Eurex, we spent a lot of time discussing whether we should introduce a basket future based on the different EMU government bonds. Our members said, “No, stay with the Bund future because the Bund is the benchmark.” This has been true up till now. The Bund remains the main product in this field. However, Matif recently introduced basket futures on the 30-year and 10-year bonds. We'll see if this is a success or not.

In the stock markets, the convergence will not be that high. We were involved in the creation of the Stoxx indices, a group of indices based on companies located in the EMU. That has proved to be strong competition to the Eurotop index, which is traded at Liffe and in Amsterdam. Morgan Stanley is creating another European-based index. For the time being, there will be some competition, and we will see in a year or so which index is the most accepted. I put my trust in Stoxx.

Onak: Leo, do you agree with Jorg about the threat posed by proprietary trading systems?

“The CBOT is probably the last-built trading floor on the planet earth. But the New York Stock Exchange wants that honor.” —Leo Melamed

Leo Melamed: I do. I thoroughly agree that the challenge for exchanges in the coming years is proprietary electronic systems. They are viable and challenging. Although the Cantor experience hasn't yet produced any grand results, I still think it is a capable challenger. Certainly, EBS has proven itself, and there are any number of potential proprietary systems out there that can easily launch an attack.

However, it's much harder to construct a system that would be connected with a clearing entity. Any electronic system that is unconnected with a creditworthy clearing entity is not going to make it. Nobody in his right mind would suddenly jump to trade somewhere with a credit system that hasn't been tested by the marketplace. Eurex has an excellent clearing system, and so does the Merc, the CBOT, and the London Clearing House. The National Association of Securities Dealers, for instance, is extremely interested in doing electronic trading. It is a very competent and formidable challenger. But unless it can demonstrate that it has the clearing capability, it will have to join Eurex, the LCH, the Merc, the CBOT or some other group that has the experience.

Having said all that, it's clear that electronic trading is here to stay and that it will continue to overwhelm the former architecture of open outcry for the obvious reasons. The CBOT floor is probably the last-built trading floor on planet earth. But the New York Stock Exchange wants that honor.

In the long run, the floor will capitulate to electronic trading. We who launched Globex back in 1987 recognized that truth. It's long in coming, but the time span is going to get shorter from here on in.

Onak: What alliances between exchanges do you see five or 10 years down the line?

Melamed: I think there will probably be two major systems for trading. I say two because in most areas you want the competition of two. Microsoft is not good for anyone. The two systems will accommodate each other in certain ways but they will compete, and they will probably have two different clearing organizations, both of them quite competent. And they will API to everybody, so it won't really matter to the end-user on the screen, because that person will not know where that trade was executed. Nobody will care as long as it's cleared at a capable, creditworthy institution. But I hope there will be two separate systems.

I might characterize them as one European and one American, but it doesn't have to be that way. We're all globalizing so very, very fast that geographical lines of demarcation are almost silly.

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