Ben Laurance
Share World
It was Lewis Carroll’s Humpty Dumpty who created the precedent. “When I use a word,” he said, “it means exactly what I want it to mean – neither more nor less.”
Now, 127 years after Through the Looking Glass was published, Alice has come to Wall Street. A hedge fund – a fund that tried to make money by exploiting tiny aberrations in the market – required a $3,5-billion bailout.
And it boasted the majestically inappropriate name of Long-Term Capital Management. Long-term this fund certainly ain’t. It is one of the new breed of funds that have sprung up within the last decade and make (or try to make) a profit out of investing in all manner of futures, options and other financial exotica.
For the super-rich, it offered the opportunity to make enormous returns – and for some time delivered them. Long- Term Capital had a reputation of being a relatively low-risk hedge fund, but “relatively” is the crucial word here. Risk is the whole point of hedge funds. They use the derivatives markets to gear their operations.
The affair of Long-Term Capital – and you can bet your last call option we will hear more about trouble at the derivatives market – highlights several key issues about hedge funds and the derivatives markets generally.
Firstly, the funds are unregulated. If a regulator wants to boss around a fund domiciled in the Cayman Islands, what can it do? Precisely nothing. All it can hope to achieve is to prevent banks under its umbrella from doing reckless business with these funds.
Secondly, the scary thing about derivatives and hedge funds is our sheer inability to quantify exactly what sums might be involved if financial markets suddenly lurched in an unexpected direction. Billions of dollars? No, trillions. The techniques used by hedge funds – playing around with options and futures, borrowing money from here to provide collateral there – allow enormous gearing.
In fact, the actual potential exposure of the financial system is considerably less than the multi- trillion totals touted around: the risk of a loss if event A takes place is offset by the promise of a profit if event A does indeed transpire. Nevertheless, our inability to work out the net potential exposure is worrying.
And that ties into the third point. There is no way that the complex mathematical constructs at the heart of derivatives deals are going to be understood by those at the top of the organisations dealing in such instruments. To use a decades-old Galbraithian term, power devolves to the technocracy – to those who can get their rocket-scientist minds around the technicalities.
Of course, the authorities want to ensure that an institution’s position has been correctly calculated. This is not the sort of thing that can be done on the back of an envelope: regulation such as this requires people and systems whose cleverness and sophistication can match the cleverness and sophistication of those doing the deals in the first place. This is not an easy situation to achieve.
Early last year, Howard Davies, then still at the Bank of England, delivered a prescient warning about the risks inherent in how individuals dealing in derivatives are rewarded. If they do brilliantly well, they receive huge bonuses; if they lose mightily, it is their employers who pick up the bill. This asymmetry is bound to act as an incentive to dealers in this market to take big risks.
Finally, if this debacle yields one useful lesson, it is this: in matters of investment, there is a world of difference between being clever and being wise. After all, long-Term Capital had the services of two Nobel prize- winning economists who won their spurs by writing brilliantly about the theory of derivatives. One of them was half of the duo who put their name to the brain- scrambling Black & Scholes model upon which virtually all subsequent theory has been built.
Even the cleverest participant in the derivatives market can make predictions only up to a point: he or she can say only that as long as volatility in this area or that is X, then the risk to funds is Y. They cannot predict the Kobe earthquake (which in part led to Nick Leeson being caught out)nor the tumult in Russia (which appears to be largely at the root of Long-Term Capital’s problems).
And after all, this is a zero-sum game: when you win a tenner by picking the winner at Turffontein, the bookie loses a tenner; when you lose, the bookie wins.
When it comes to hedge funds and derivatives, the sums are much larger, but the principle is the same: there will always be someone as smart as you on the other side of a bargain. The difference, of course, is that it is a shame if a bookie is bankrupted. If a bank goes the same way, it could spark catastrophe.