Are we nearing the end of a great age of financial creativity, or is this just the beginning? Some pros peer into their crystal balls.

By Barclay T. Leib

The pace of change in the derivatives world over the past five years has been breathtaking. It's difficult now to imagine a time when the credit derivatives market was young and immature; when energy derivatives were obscure and thinly traded; when insurance and weather derivatives were little more than intellectual daydreams; or when the concept of Internet-based risk management was truly laughable. Yet that was the case just 60 months ago.

Because derivatives markets have grown so quickly, it's tempting to wonder if there's anything left to be invented. But such thoughts always seem quaintly naive over time. Of course financial products and risk management will continue to evolve—the only question is, How quickly? Are we nearing the end of a great age of financial innovation, or is this just the beginning?

To answer these questions, we asked a number of industry professionals in various segments of the market what the five greatest changes in the derivatives world are likely to be over the next three years. Not surprisingly, the improved delivery of existing products over the Internet was the first topic most people brought up, although the impact of the Internet on future market liquidity proved a more controversial topic. Predictions ranged from Internet-based trading leading directly to a financial market seizure of some sort to a new golden era of increased transparency and uniform trading platforms.

We heard more widespread agreement that whatever changes take place in the next few years will be driven largely by the regulatory environment—whether onerous (forcing the creation of ingenious new products) or lax (encouraging stepped-up trading in areas that might previously have been off-limits). Derivatives, says William Margrabe, president of William Margrabe Group, Inc., have always been used "to meet existing human needs to manage risk, avoid taxes, snooker the accountants and get around pesky regulations. As people get more legally ingenious, they use derivatives to get around laws. The entire swaps business started that way. And every time we see regulation weaken a bit, we see a flurry of activity.” Keith Schap, of the Chicago Board of Trade market and product development department, concurs with Margrabe, saying, "complex instruments are the response, not the stimulus.”

So what specific changes are in store? Here are some possibilities.

The regulatory scene

The repeal of Glass-Steagall is expected to throw the financial world into a dizzying state of convergence. The insurance industry is likely to be at the center of the changes.

For starters, the blurry, amorphous banking-insurance industry will continue to slice and dice event risks in more innovative ways, and spread these risks to more people who have an interest in absorbing them for diversification plays. Morton Lane, president and CEO at Lane Financial LLC, sees great growth prospects in the multiple-event cover market—in which, say, a company might want protection from a high electricity price and rising interest rates. "There is a huge potential demand for dual-triggered types of products,” he says. Lane also sees trigger events becoming much more flexible and more narrow than the catastrophe bonds of today—such as products in which, for instance, a bond pays a coupon indexed to wind speed. According to Lane, all new innovations typically take time to gestate and await the right regulatory impulse. So while event-risk derivatives "came, went, and are not a huge market now, they will likely come back with time” now that Glass-Steagall is behind us once and for all.

With time, one can imagine derivatives on individual business risks such as an overly hot or snowy weather, overly expensive fuel costs or an overly expensive labor force. Taken to the extreme, earnings-per-share insurance products might even be possible as well, but it won't happen right away. "A few intermediate steps must come first,” says Richard Sandor, chairman of Environmental Financial LLC. "I'd look for derivatives on factor inputs first, such as jet fuel, load factors and wage costs, before we finally put the whole picture together to have derivatives on earnings-per-share.” Margrabe also has little doubt in the next few years that "banks and life insurance companies will make more variable annuity products available to retail investors, combining management of mortality risk and market risks.”

"While event-risk derivatives came, went, and are not a huge market now, they will likely come back with time.” Morton Lane Lane Financial

But while the repeal of Glass-Steagall will be momentous, the Commodity Futures Modernization Act of 2000, currently on the floor of the House, could completely alter the way derivatives are regulated. Within that bill, which will renew and update the Commodity Exchange Act of 1936, there is a proposal for single-stock futures (see "Get Ready for Single-Stock Futures,” Page TK). If passed, the Commodity Futures Trading Commission and the Securities Exchange Commission will be forced—past animosity notwithstanding—to work much more closely together. Could a merger of these two entities for simple logistical reasons soon be in the cards?

That is a question to which most would continue to answer no, but Leslie Rahl, president of Capital Market Risk Advisors, concedes that "the merger of financial institutions will eventually force these two entities to make deals together.”

And the great white elephant of the corporate world, Financial Accounting Standard 133, will undoubtedly inspire innovation. Once the standard is finally implemented, says Ron Dirusso, head of currency options trading at Lehman Brothers, "don't be surprised to see a few banks come up with products designed to, well, get around it.” For instance, under FAS 133 forwards will still qualify for accrual accounting, while options will not. The result, says Dirusso, will be that forwards, on the margin, will become more popular, whereas options may be packaged with other products to smooth out the option's return characteristics. "Firms are currently working to design products that minimize the time value variations within options,” says Dirusso. He stops just short of giving a name to this new product, keenly aware of revealing too many ideas in a competitive world.

Hot asset classes

While many do expect single-stock futures to emerge as the biggest new equity derivatives product of the next five years, others aren't so sure. When fixed income futures and options were developed, they fulfilled a natural need to hedge forward cash flow fluctuations. The specific advantages for individual stock futures are less clear. It may be that they succeed simply because they help level the playing field for short selling—moving current day stock-borrowing problems onto a more standardized platform.

Environmental derivatives are also expected to thrive in coming years. Richard Sandor claims that some $3 billion to $4 billion in environmental OTC contracts are currently being traded between the power and energy companies—and that's likely just the tip of a growing trend. The 1997 Kyoto Protocol has spurred the development of a nascent market in greenhouse gas (GHG) reductions, sulfur dioxide (SO2) credits, and nitrogen oxide (NOx) allowances. Environmental-trading company Natsource already arranges swap transactions on these permits, as well as outright forwards and options thereon. In keeping with the regulation-begets-innovation theme proposed here, this market seems poised for huge growth in the next few years.

To Sandor, on an overall basis, we have just finished the age of homogeneous derivatives products as represented by the fictitious 8 percent long-bond contract he first helped to develop over 20 years ago. "That was necessary back then to bring people together—to ensure liquidity,” says Sandor. "With the ease of screen-based access, there's far less need for that now. I think we are moving into a ‘deconstruction' phase to these markets. We'll soon be trading far more customized products.”

Few in the industry would agree more than Richard Jaycobs, CEO of onExchange. He sees a huge new diversity of products developing "to hedge such things as service costs and healthcare costs, just as Priceline.com created a new way to buy airline tickets.” As some of these business risks become more visible, more transparent and hedgeable, Jaycobs expects people to want to control their suddenly more quantifiable risks. onExchange hopes to be standing in the middle of these new markets.

"I see more principal-to-principal trading in what some might consider low-volume markets,” says Jaycobs. "Speculators and market-makers will come later, not at first. I also think there will be more of a move to ‘multilateral credit' with a central repository of credit emerging to facilitate the clearing of trades.”

"With the ease of screen-based access, there's far less need for standardized contracts. We'll soon be trading far more customized products.” Richard Sandor Environmental Financial

Meanwhile, back on the traditional exchanges, the recent emergence of futures and options based on agency debt has been the first step in a long overdue exchange venture into credit-oriented contracts. According to CBOT's Schap, "the agency futures launch has in many ways been the most successful new contract introduction ever. Expect further developments along these lines.”

Volatility, correlation and long-dated options

Since the 1998 financial meltdown, and for reasons that are not entirely clear, correlations between major global equity markets have reached historic lows. Various equity markets have taken turns in the driver's seat of performance with other markets playing catch-up at strange moments in time. Even within the U.S. market itself, there have recently been some historically unprecedented divergences between the NASDAQ Composite and the Dow Jones Industrial Average.

In such an environment, one would expect the demand for correlation options and variance swaps (paying off on actual volatility vs. a given strike) and volatility options (paying off against a benchmark implied volatility vs. a given strike) to be increasing—and it is.

Right now, volatility products "are in their infancy,” says Eric Reiner, managing director at Warburg Dillon Read, "and we're beginning to get a better handle on a good correlation product that isolates correlation the way a volatility swap isolates volatility.”

Eric Henn, a Germany-based research expert who recently completed a Ph.D. thesis on volatility trading, says the risk of volatility changes is just as important as the delta risk of an option, and "should not be as neglected as it is now.” Henn believes that volatility and correlation products are going to become more and more popular in the years to come, because volatility is at the heart of all trading activity.

Already, the VIX Index, which calculates the 30-day at-the-money implied volatility of OEX options, has created considerable interest from the hedge fund and money management community since the CBOT first introduced it in 1993. Post the 1998 Long-Term Capital meltdown, fund-of-funds allocators increasingly look at a hedge fund manager's performance in relation to this index before investing. The VDAX Index, created by the Deutsche Borse in 1997, has also grown in popularity. Futures or option contracts on these indices could be a natural.

Alex Lipton-Lifschitz, head of foreign exchange product development at Deutsche Bank New York, is quite keen on such a prospect, as well as various over-the-counter varieties. He sees "long-term holders of equities as natural buyers of options on volatility, while for a price, dealers and trading desks will sell them.” If a bank sells volatility options it could perhaps be a natural hedge to a bank's underlying trading business, where too quiet a year can impinge profitability.

Lipton-Lifschitz also thinks the actual models that dealers use and how dealers look at a volatility surface going forward will become increasingly important. "Those not able to master volatility smile—whether it be considered stochastic or deterministic—are not going to be viable players in the field three years from now,” he says.

Finally, nowhere is the handling of volatility skews more magnified in importance than in cases in which one deals in longer-dated options. So as the models become more concerned about and able to deal with an entire volatility surface and movements in a forward price curve, one might also expect a greater willingness to quote and trade longer-dated options. Lehman's Dirusso sees longer-dated options as "a key part of my business likely to expand.” So too does Lipton-Lifschitz. "Right now the market is not very deep going out three to five years in currency products, but that is going to improve soon.”

Exchange overhaul

"The biggest change in the next few years, bar none, will be that the U.S. exchanges will be dragged, kicking and screaming, into the world of electronic trading,” says Keith Schap of the CBOT. Even though Schap recognizes that this is a delivery change, not an innovation, he believes it will be of utmost importance and will represent a true "democratization of trading.” "Anybody with a PC will be able to join in,” he says. "Transaction costs will drop, the number of intermediaries will be reduced. Brokers will no longer just be able to write tickets and claim to deliver better execution to add value and stay in the picture. The ones who survive will have to demonstrate an ability to give their customers an information edge.”

Many think that when the CBOT flips the switch to allow electronic trading of the Treasury bond contract during daytime hours, it will not be a question of whether the traditional trading pits survive but simply how long. One of these is CSFB's Schouten, who sees the "electronic revolution pushing the market-making functionality almost completely upstairs.”

"Ninety-five percent of derivatives transactions by notional value will be web-based,” adds Margrabe. "The derivatives market middlemen will take major hits as end-users are able to find each other more easily face-to-face. ECNs will replace trading pits, just as the NYSE trading floor replaced quaint, outdoor trading under the Buttonwood Tree.”

Meanwhile, Jaycobs of onExchange sees the order-matching process moving away from a simple price/time priority. According to Jaycobs, systems will be able to blend complex three-way pricing and deal structuring. "Trading, say, a strip of eurodollars is hard to do on most current electronic trading systems in an efficient way,” he says. "But via some of these new platforms, it would be a snap. The matching of orders is going to become far more sophisticated in the financial markets.” Jaycobs also believes that, in some markets, the importance of anonymity in concluding a deal will decline. "Sometimes it's more important to know the grade of a product and the access of the seller to the product than anything else. These are both qualitative inputs that will demand different matching algorithms from simple price and time.”

The middle and back office

The Internet's transformative effects on the middle and back offices are only starting to be felt. At the very least, back-office processing will undergo dramatic change. "There is no doubt in my mind,” says Till Guldimann, senior vice president at Sungard Data Systems, "that outsourced derivatives back offices will be a big development.”

Why? Every bank has a backlog of unsigned confirmations and high costs of bilateral agreements, rate setting and credit monitoring. The Internet and other technological advances can help cut these costs dramatically, says Jerry del Missier, a Barclays Capital managing director in charge of global markets, who sees a "real focus developing to kill the costs of all this.” Instead of deals piling up in unfinished files for months, a more streamlined and standardized confirmation process is likely to develop over the web.

The very process of deal capture is also likely to see dramatic improvements in exception processing. Right now, some estimate that 10-20 percent of transactions account for 90 percent of the back-office costs. But both del Missier and Guldimann see a huge growth in straight-through processing to address this problem. "Right now there are just too many fingerprints on these trades,” says Guldimann, "but the machinery with sufficient adaptability and flexibility to handle these deals is coming. These will be inference-engine-based systems, otherwise known as artificial intelligence.”

Dirk Ward, chief technology officer for Deutsche Bank, agrees. "Some operations and credit efficiency problems might have been dealt with before the Internet, but there wasn't enough competitive pressure. Now, e-commerce competition is serving as a catalyst for both funding and processing change in these areas.” Del Missier of Barclays sees end-user pressure driving the growth of multi-dealer risk management portals until the market eventually achieves real-time 24-hour turnaround of documentation and confirmations.

Accidents will happen

The move toward electronic trading platforms complete with financial portals and back offices may be an inexorable trend good for certain firms, but how will the financial system as a whole be affected by the change?

Believe it or not, many believe market liquidity could suffer. "The increased automation of the securities markets creates great margin pressures on the market-makers and forces them to retreat,” says Guldimann. "As a short-term consequence, liquidity is reduced. This is reflected in today's extreme intraday and interday price volatilities, which can hardly be justified by market uncertainty and long-term expectations.”

"The emphasis will shift from refining market-risk models to developing risk models that capture the interaction of market, credit and liquidity risks.” Michael Zerbs Algorithmics

Because of this lack of liquidity, some see a major financial accident developing. "With more traders who are less well-capitalized and less knowledgeable entering the picture, and fewer intermediaries to warn and counsel, the train wrecks could be staggering,” says Schap. "The equity day-trading horror stories the journalists are ‘tsk-tsking' about now could pale in comparison.”

Exactly when and where such accidents will happen is anyone's guess, of course. Growing leverage won't help matters. Leslie Rahl of Capital Markets Risk Advisors says that while "the market previously shied away from leverage for a time, it has become attractive once again.” One area that she believes could experience a financial accident in the next few years is the repo and securities lending area. "There's just too much leverage operating there on too fine a margin,” she says. Meanwhile, Schouten of CSFB says that equity derivatives risk has been reduced significantly since 1997-1998, but he still allows for some problems, "from knock-out knock-in risk under the market that is always there and potentially very dangerous.”

Margrabe, meanwhile, believes that as competition from electronic portals increases, "More than a few financial institutions will learn new lessons about the difference between ‘paper profits' and cash profits.” According to him, at certain less careful institutions, "soaring profits on a growing number of new deals—particularly exotic ones—have overshadowed realized losses on the smaller number of maturing swaps and expiring options. Competition from ECNs will slow, stop or even reverse this process.”

But if there is a financial accident of some sort, Guldimann thinks this will precipitate the development of a whole new market in liquidity derivatives. "People won't be able to exit at any price, and a real freeze-up will occur,” he says, "and then products will be developed to avoid the same thing happening in the future. What would you pay me for the right to sell some security or basket of securities at 90 percent of yesterday's 3 P.M. price? Not much, right? But someday there is going to be a demand for exactly that type of rolling option. Maybe they'll be written by long-term investors as enhancements.”

Sandor is far more optimistic. He says he has been hearing about fractionalized liquidity and possible financial accidents for far too long. "I first heard about it when they introduced stock options, then when we first introduced stock index futures, then when we introduced NASDAQ 100 futures. Liquidity has only been getting bigger and better throughout, despite all the naysaying prognostications.”

Asset management

The 1990s saw the development of total return swaps on hedge fund and fund-of-funds performance to allow high-net-worth individuals to pledge a certain amount of collateral while they leverage themselves into betting on another asset's performance. Going forward from this base, don't be surprised to see an option market on hedge fund performance slowly develop.

Already, Lehman Brothers and a few others are offering clients "expert trader” options wherein you pay a fixed premium to receive all of the upside of a given manager, but without any risk beyond your upfront premium cost. The key for the writer of this option is to be able to see what a hedge fund manager is doing and delta hedge his trading actions. As hedge fund transparency and liquidity increases—as it already has with such ventures as Plusfunds.com, a new multimillion dollar platform, and Hedge Fund Trust, an associate of Hedgeworld.com—so should these types of products.

While it may sound a bit crazy at first, might you want to spend 5 percent to take a punt on Louis Bacon or Bruce Kovner? Or how about 7 percent for a free ride on the slightly more wild Andy Krieger or Nassim Taleb? It's obviously not as cheap a fee path as simply investing with one of these fund managers directly, but it has a certain attraction to more risk-averse investors.

Of course, where such an option can be explicit, it can also be implicit in guaranteed note products, which are already quite popular. If returns from traditional fixed-income and equity investing diminish, this alternative asset packaging business could blossom. CSFB refers to this business as "fundling”—the repackaging and amalgamation of hedge fund managers and derivatives into acceptable securitized transactions for the masses. "This is a huge and growing business,” says CSFB's Schouten.

Lastly, don't be surprised to see the distinction between hedge funds and traditional fund management blurring somewhat. According to Guldimann, traditional money managers have long hesitated to use derivatives primarily because of a lack of accounting consensus and the scarcity of easily accessible risk management products. But those impediments are quickly disappearing. Michael Zerbs, vice president of research and product marketing at Algorithmics, explains: "Over the Internet, many advanced trading and risk management tools are becoming available to a large buy-side audience for the first time. Building on emerging standards such as Mark-to-Future (MtF) or RDML, application service providers offer a variety of products and services, making it possible [for the first time] for corporates and asset managers to assess the potential benefits of derivative strategies to their portfolio.”

The net result, according to Jerry del Missier of Barclays Capital, will be "a certain amount of convergence between the hedge funds and the mutual funds as this latter group starts to embrace these products.”

If corporates and traditional fund managers finally embrace derivatives, there may also be an increased emphasis on managing risk over time, not just at inception of a trade. "A Bermuda swaption that can be delta-hedged easily today may have very unstable hedge ratios in the future,” says Zerbs. "Assessing counterparty credit risk also requires long-term simulations. To gain a forward-looking view of market and credit risk, financial institutions will place more emphasis on ‘completing' pricing models, such that they support simulations over time. On a broader basis, the emphasis will shift from refining market-risk models to developing risk models that capture the interaction of market, credit and liquidity risks.”

Have we left anything out? We most assuredly have, the possibility of a whole new derivatives market on bandwidth trading being one specific topic that clearly deserves its own space. But even without considering this, the consensus among our experts is that we'll see as many changes in the next three years as we have in the last. Internet delivery may be an important component of this change—and perhaps even the cause of some new product offerings—but the Internet will not be the only innovation we are likely to see. It will simply be the newest modicum around which the financial engineers of Wall Street will build.