Viewpoint: Paul Wilmott

The Problem with Derivatives, Quants, and Risk Management Today

Biographies: Paul Wilmott

Introduction
Paul Wilmott is a financial consultant, specializing in derivatives, risk management and quantitative finance. He has worked with many leading US and European financial institutions. Paul studied mathematics at St Catherines College, Oxford, where he also received his DPhil. He founded the Diploma in Mathematical Finance at Oxford University and the journal Applied Mathematical Finance. He is the author of Paul Wilmott Introduces Quantitative Finance (Wiley 2007), Paul Wilmott On Quantitative Finance (Wiley 2006), Frequently Asked Questions in Quantitative Finance (Wiley 2006), and other financial textbooks. He has written over 100 research articles on finance and mathematics. Paul Wilmott was a founding partner of the volatility arbitrage hedge fund Caissa Capital which managed $170million. His responsibilities included forecasting, derivatives pricing, and risk management. Dr Wilmott is the proprietor of www.wilmott.com, the popular quantitative finance community website, the quant magazine Wilmott and is the Course Director for the worlds largest quant education programme the Certificate in Quantitative Finance (www.cqf.com).

The press has recently vilified derivatives and Warren Buffett famously called them weapons of financial mass destruction. Whats your feeling?
A decade ago, I wrote about how the derivatives market now exceeded the size of the underlying market. Small quantities of derivatives are fine, but if you look at the derivatives trading on the back of IBM or HBOS shares, the sheer quantity of trading that goes on is both worrying and lethal to the health of the underlying companies as well as the broader economy. If you can make some money on a small number of derivatives, then people will naturally lever up to make greater returnsand thats when things get dangerous. Banks have being selling these instruments for years now without worrying about the repercussions. Im surprised that just because Warren Buffett started talking a few years ago about the danger of derivatives, people started wondering for the first time, Hang on, can that be right? Its staggering how little people think for themselves.

Whats the solution, then, as derivatives seem here to stay, be it for hedging and portfolio efficiency, or for unique different trading strategies? Is the answer greater transparency as some people have called for?
Im not sure greater transparency would help. Ratings agencies and regulators go into banks all the time to examine their instruments and models. The problem is that they are all using similarand poorrisk models, and everyone is doing the same trades in large numbers and sizes. A ratings agency, for example, will walk into one bank and see what trades theyre doing. It will then go into the neighboring bank and see the exact same trades. Realistically, anybody should have immediately seen how dangerously correlated the whole system is. There is plenty of transparency at the moment where regulators and ratings agencies are seeing this. The problem is that they all still sign off and give the Triple A ratings. For me, there is a distinct moral hazard in the way ratings agencies are compensated: banks and companies pay them millions of dollars to get ratings, which creates a system that is inherently conflicted. When the lawsuits start in a few months time, I hope that ratings agencies will suffer the largest damages. As well as transparency, you need someone to do something about what they seeand that simply isnt happening today.

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What about the regulators, then? Increasingly, there have been calls for greater regulation to solve the problems within the system, such as the nature of compensation.
As far as regulations are concerned, there are two sorts that should come into force. The first is diversification. You have to diversify and spread your risk amongst a range of instruments that are as uncorrelated as possiblethat reduces risk. However, this will be very hard to implement, and an alternative might be to instead target limits on the large quantities that banks can otherwise trade in a small pool of derivatives. The other issue is compensationand that can be regulated. We have got to stop compensating people for taking ridiculous risks with other peoples money, and this could be implemented in a day if politicians really wanted to. There are lots of ways to do this. Link the compensation to the maturity of the instrument. If a banker is responsible for putting together a five-year CDO (collateralized debt obligation), trickle out their bonus over five years. Then, you have a system similar to the royalties that musicians receive long after they have recorded a song. This also encourages people to trade shorter-term instruments that have greater transparency. Pay their bonuses in company shares, for example, so that they bear the risk of loss. If you stick with the current status quo, where bankers get paid on the upside annually without any downside risk, then youre still encouraging them to bet as much of other peoples money as possible, with obvious and now well-known consequences. The compensation needs to be smaller as well. Bankers cant be paid the vast amounts theyre receiving now for risking other peoples moneyits just not morally right.

Lets talk about the instrument thats been most in the press, credit default swaps (CDS), where the size of the market has become ridiculously large compared to the companies whose defaults theyre underwriting. What do you see as their future?
Nassim Taleb and I have talked out for years now about the size of these markets and how, in some cases, youre even buying protection on a company from itself, which seems crazy. These risks have always been clear but no one has ever admitted it, as theyve all been busy making too much money. To deal with the problem, you can set up an exchange and have standardized contracts. With simple CDS, this can give greater transparency as people can see how many there actually are. But more complicated structures are harder to standardize. While theres nothing inherently wrong with these, it is essential to see how many are being used for hedging and how many for speculation, as you cannot have more speculation than there are underlying assets. Most should really be used for hedging, such as companies looking to hedge the risk of their suppliers going bust. Otherwise, you increase the risk of contagion and systemic failure, as no one knows who the ultimate counterparty is. Their sheer size also matters, as it wouldnt matter if these contracts were traded in small quantities. But the quantities are so large, and everything is continually repackaged and moved from one bank to another, that no one knows anymore how much there actually is out there and, more importantly, how much is still outstanding. You need to see who has what, and who theyre trading with.

One thing that seems certain is that leverage is not going to be the same going forward. Whats the bank of the future going to look like?
In some ways, it wont be all that different. Banks will always hire expensive quants, accountants, and lawyers to work their way around these obstacles. Leverage had been crazy and there might well be some regulation, but there will doubtless also be people to get around this.
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Also, people forget. Once a disaster is over, people very rapidly forget how bad it was. So I dont know if banks will really changeit just depends on if regulators will bring in new laws before people get bored and move onto the next disaster.

Hedge funds have been particularly blamed for their role in the credit crunch. Were they culpable or just one of the culprits, along with banks and those investors who drove the demand for securitization?
Hedge funds do have a role, though not as big as the banks. Hedge funds are largely all the same, i.e., they follow fashions in strategy. This makes them dangerous as they all end up in the same trades, but people are largely wary of them. Also, the investors in hedge funds are people with lots of money and expertise, while many of those in banks are normal peopleyour man on the street who cant afford to lose his money. Banks are supposed to take excess money from people with too much and lend to those with too little money, to do useful things such as buying a house or starting a business. Banks should not be lending to people to buy trivial items that should be saved up for, such as Christmas presents and shoes. Banks are ultimately responsible for the credit crunch as they extended such easy credit to people to live far beyond their means.

The problem has now moved on from the financial sphere into the real economy. How do you wean people off this easy credit?
Thats an important consideration. Can it be done gradually or should it be undertaken with a short, sharp shock? There is a generation of people today around the age of thirty, who have only ever lived off credit. How will they survive without credit? If you tell them they cant have the latest iPhone, its going to be a shock to them. Its symptomatic of the society we live in, where we believe the economy has to keep growing, otherwise all hell breaks loose. Running is the new standing still, so to speak.

Quants have also had a rough ride recently thanks to CDOs and the like. What are your thoughts and what is the future for them?
Once banks have been exposed to quantitative methods and approaches, its hard to go back to the old world. So, they are here to stay despite their large role in the credit crunch. Without quants, you wouldnt have such methods as value at risk (VaR) to quantify the risks we are running. Ironically, the problem is that once you start quantifying risks, you can also manipulate them. VaR is a perfect example where, thanks to your underlying assumptions and models, you can believe there is no risk. In reality, youre likely running lots of risk but, by reporting such a small amount, its possible to trade bigger and bigger amounts. So, in some cases, the consequences of measuring risk better is that you end up with more! There are also different types of quants. I train more quants than anyone else on this planet, and there are two typessensible and stupid. Unfortunately, the stupidthe purist, abstract mathematics-loving quants are in the majority. Let me explain. Many quant books contain vast volumes of unrealistic mathematics. Some people get carried away with the beauty of this mathematics with no corresponding understanding of finance and, more importantly, of human nature. These people are dangerous, as you cannot talk to them about the real world. If you tell them their models do not work, theyll talk of all sorts of abstract notions, proving themselves right in their heads. Unfortunately, all this is without any reference to the real world. And in financewhich is as much about people as mathematicsif you cant grasp that, then that is dangerous.

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I have always advocated the mathematics sweet spot, that fine balance between a sufficiently advanced knowledge of mathematics to do the job in the real world, while not being so abstract as to lose your head in the clouds. You must not dumb down quantitative math, else you cannot understand more complicated derivative products. But, equally, you do not want to stray into the even more dangerous area of really highlevel math, where people get carried away by the subjects beauty. There are some 5,00010,000 Masters in Financial Engineering graduates churned out each year, and I would not employ a single one of them myself, as they are so hopelessly out of touch. I hope that everyonepeople, banks, risk managers, hedge funds, governments, and regulatorsall realize that while a certain level of mathematics is important, transparency and robustness in the models are the key, not valuing derivatives to 10 decimal places.

People often dont realize that any theory is only as good as its axioms. So what can be done about this?
They just love the mathematics, which is fantasticI love mathematics too. But if thats what you want, then get a job in a university or do it in your free time. Dont do it in the banks time. Im a great believer in quantifying everything, but are we actually dealing with a science? Finance is a very soft scienceits a science because you have all this data that you can analyze, but its also soft because, despite all these theorems, human beings have an annoying habit of not obeying the rules. So while there is always going to be a need for mathematics, we need people to ask difficult questions. When these quants with their PhDs are talking math, intelligent people have got to have the confidence to ask them the difficult and embarrassing questions, such as When do your models break down? Similarly, risk managers need to act as devils advocates. They need to ask, Weve lost a billion. How did that happen? At the moment, its the other way round as people look only at scenarios. The problem is that everybody misses one, such as Long-Term Capital Management (LTCM) overlooking the scenario where all their uncorrelated risks suddenly all became correlated. However, there is an implicit moral hazard too, as managers know that if there is a bad enough scenario with high enough risk, the bank wouldnt be allowed to trade, so they may choose not to acknowledge some risks at all, such as rising defaults. One of my favorite examples of the need to think outside the box is the magicians card trick, where he hands an ordinary pack of cards to a random member of the audience, and asks another random person to pick a card. The person says ace of hearts, and the magician now turns back to the first member, feel around inside the deck and pulls out a card. What is the probability of that card being the Ace of Hearts? Most people would say one in 52. But you have to think of where all this is happening. Youre in a magic show, so you expect something impressive. The other obvious answer is that the probability is one. This is such an important question because most quants will say one in 52, a few will then stop to consider, and fewer still will take the magic element into account. But you do need to consider these possibilities. If you have $1bn riding on it not being the ace of hearts, and every time the magician picks a card it is the ace of hearts, youve just lost $1bn. Risk managers have to be able to think laterally, though even realizing just these two scenarios is not good enough. Picking the ace of hearts may just be boring. Maybe its a different trick, where he picks the wrong card and the ace of hearts is actually in the second persons pocket. Perhaps the card instead contains the winning lottery numbers for that night, which will be chosen in 15 minutes time. One in 52the quant answerdoesnt even begin to scratch at the possibilities.

Lets end with the question that resonates most in the minds of financial leaders these days. What lessons, if any, can we take from the credit crunch?
I dont actually think there are any lessons to learn, as we cannot expect people to stop having a herd mentality. As far back as 2000, I warned about a mathematician-led market meltdown, thanks to the dangers of all these credit instruments and what quants were doing. It was all there for everyone to seebad models,
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self-serving regulations, the moral hazard with the compensation schemes within ratings agencies, and so on. But people in general are like sheep. So, the lesson for me is the same old lesson that people will always make the same mistakes. There will doubtless be new regulations, but there will also be people who will be paid tremendous sums of money to work their way around these regulations. Fundamentally, it comes back to my earlier point that what has to change is the way people are compensated. With the way the bonus structure is currently set within banks, people take as much risk as they canthey wouldnt care if they blow up the entire banking system as long as they got their tens of millions of dollars.

More Info
Books:
Wilmott, Paul. Frequently Asked Questions in Quantitative Finance. Chichester, UK: Wiley, 2006. Wilmott, Paul. Paul Wilmott on Quantitative Finance. 2nd ed. Chichester, UK: Wiley, 2006. Wilmott, Paul. Paul Wilmott Introduces Quantitative Finance. 2nd ed. Chichester, UK: Wiley, 2007.

See Also
Best Practice Dangers of Corporate Derivative Transactions Viewpoints Viewpoint: Maureen J. Miskovic Viewpoint: Riccardo Rebonato Checklists Derivatives Markets: Their Structure and Function Establishing a Framework for Assessing Risk

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