Good Derivatives E-Book

Richard L Sandor

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 1004

Veröffentlichungsjahr: 2012

Beschreibung

Through the eyes of an inventor of new markets, Good Derivatives: A Story of Financial and Environmental Innovation tells the story of how financial innovation - a concept that is misunderstood and under attack - has been a positive force in the last four decades. If properly designed and regulated, these "good derivatives" can open vast possibilities to address a variety of global problems. Filled with provocative ideas, fascinating stories, and valuable lessons, it will provide both an insightful interpretation of the last forty years in capital and environmental markets and a vision of world finance for the next forty years. As a young economist at the Chicago Board of Trade, Richard Sandor helped create interest rate futures, a development that revolutionized worldwide finance. Later, he pioneered the use of emissions trading to reduce acid rain, one of the most successful environmental programs ever. He will provide unique insights into the process of creating these new financial products. Covering successes and failures, the story describes the tireless process of inventing, educating and creating support for these new inventions in places like Chicago, New York, London, Paris and how it is unfolding today in Mumbai, Shanghai and Beijing. The book will tell the story of the creation of the Chicago Climate Exchange and its affiliated exchanges (European Climate Exchange, Chicago Climate Futures Exchange and Tianjin Climate Exchange, located in China). The lessons learned in these markets can play a critical role in effectively addressing global climate change and other pressing environmental issues. The author argues that market-based trading systems are a far more effective means of reducing pollutants than "command-and-control". Environmental markets may ultimately help to find solutions to issues such as rainforest destruction, water problems and biodiversity threats. Written in an engaging, narrative style, Good Derivatives will be of interest to both practitioners and general readers who want to better understand the creative process of financial innovation. In the middle of so much distrust of markets, it is also a recipe of how transparent, well-regulated markets can be a force for good in the environmental, health, and social areas.

Leseprobe

Contents

Foreword

Preface

Acknowledgments

Chapter 1: The Early Years

The House of Sandor and Mirner

Bobby Fischer and My Days at School

Discovering Economics in Brooklyn

On to Minnesota

Berkeley Beckons

Chapter 2: Trying to Change the World

A Different Structure for a Different Kind of Exchange

Chicago—My Kind of Town

Structuring the Exchange

Talking to Regulators

The Dream Is Dashed

Chapter 3: The Berkeley Years

A New Direction

Plywood Futures—Learning How Others Create a Good Derivative

Grain Markets and Mortgages

Mortgage Interest Rate Futures—Creating Good Derivatives

Chicago Calls

Chapter 4: The Chicago Board of Trade Years

Mentors and Leaders

Trading with the Soviets

An Explosion in Grain Prices

Iron Men in Wooden Pits

The Gulf Wheat Futures Contract

Contract Improvement—The Brooklyn Farmer in Iowa

The Relationship between Futures Prices and Spot Prices

The Gold Futures Contract

Chapter 5: The Chicago Board of Trade Years

How GNMAs Work

Drafting GNMA Futures

Selling the Concept to Financial Institutions

Enabling Legislation and Regulation for GNMA Futures

Transparent Markets—Greetings from the Grim Reaper

The GNMA Contract: Simple in Concept, Complex in Detail

The First Financial Good Derivative—GNMA Mortgage Interest Rate Futures

Contracts without Lawyers

Her Name was Ginnie Mae

The Economic Benefits of GNMA Futures

Moving On

Chapter 6: Educating Users and Building the Market

Adapting at Conti

Travels with Charlie O. Finley

Finding Early Adopters

The Relationship between Prices in Different Months

Disseminating Prices

The Gordian Knot of Building a New Market

Chapter 7: Treasury Bond and Note Futures

Trading a Notional Bond

Marketing Treasury Bond Futures

Educating Users

New Interest Rate Contracts

Ten-Year Treasury Note Futures

Innovation by Competition

Commoditizing Stocks

Chapter 8: The Decade of the Eighties

Exchange-Making in London

Three Men and a Market—MATIF

The Tale of Two Cities

On to Drexel

Once a Teacher, Always a Teacher

Drexel Grows

Drexel Becomes More International

Eurodollar and Stock Index Futures Contracts

The CBOT Options on Bond Futures

Chapter 9: Globalizing Chicago Exchanges

The Secret Ingredient of the CME

Financing Entrepreneurs

Catering to a Global Market with Night Trading

The Attack on Equity Derivatives—Wet Sidewalks Cause Rain

The Demise of Drexel

Chapter 10: Environmental Finance

The Acid Rain Problem in the United States

The Clean Air Act Amendment of 1990

Starting Over

Jack Welch and Kidder, Peabody

The CBOT’s Role in the EPA Acid Rain Program

The First EPA Annual SO2 Auction

Chapter 11: Blame It on Rio

In Search of Trees—Commoditizing CO2

Caipirinhas and Climate Change

A New Academic Field

Chapter 12: The Beginning of the Entrepreneurial Years

Commoditizing Catastrophes

Selling Catastrophe Futures

Entering the Insurance Space as an Entrepreneur

SO2 Emissions Trading at Centre Financial Products

Creating New Insurance Products

Crop Insurance

Charlie O. Finley’s Death

Exiting the Insurance Space

Postmortem

Chapter 13: You’re Gonna Trade What?

The G-77 Meeting at Glen Cove

The Global Warming Emissions Trading Program (GETS)

Preserving Rainforests through Markets

The Policy Forum on Greenhouse Gas Emissions Trading

The White House Conference on Climate Change

The Kyoto Protocol

The Demise of GETS

Chapter 14: From the Pit to the Box

A Civilization Gone with the Wind

Stock Index Futures—A Postscript

The Battle of CME and CBOT

Battery Ventures

Unlocking Liffe

The Wagner Patent—Good Ideas Never Die

Chapter 15: Conceiving a New Kind of Exchange

The Largest Voluntary CO2 Offset Trade in History

The Dow Jones Sustainability Index

Sustainable Forestry and Climate Change—A Case Study of Failure

A Chance Encounter—The Beginning of the Chicago Climate Exchange

Chapter 16: The Twenty-First Century Lighthouse

Spreading the Light

Ramping Up

Preliminary Market Architecture

Educational Outreach

Refining the Preliminary Market Architecture

Recruiting Members to Design the CCX

Finalizing the Preliminary Market Architecture

Chapter 17: CCX Market Architecture

“If You’re Not at the Table, You’re on the Menu”

The First Meeting for the Utility Technical Committee

The First Meeting for the Industry Technical Committee

Consensus Building

The End of the Day

The Chicago Accord

Seeking Investors

Chapter 18: Chicago Climate Exchange

Recruiting the First Members—Voluntary Participation versus Legislative Mandate

Exchange Governance, Structure, and Regulation

The Electronic Trading Platform

The Registry, Clearing, and CCX Rulebook

The Auction

The Rocket Takes Off

Financing an Exchange

Chapter 19: The Rise of the Chicago Climate Exchange

Recruiting the A-Team

The CCX University

Educating, Marketing, and Sales

Building Demand

Building Liquidity

Building Supply

Corporate Restructuring

Extending the CCX Program

Market Highlights

Chapter 20: The Fall of the Chicago Climate Exchange

Engaging the U.S. Congress

Waxman-Markey—The Beginning of the End

Falling into a Coma

A Post-Mortem

Looking West

The CCX Legacy

Chapter 21: The Chicago Climate Futures Exchange

Setting Up Shop

Launching Sulfur Futures

Designing the Contract

The Rise

Sell, Sell, and More Sell

The RGGI Battle

Benefits of CCFE

The Fall

Closing Thoughts

Chapter 22: The European Climate Exchange

Tapping into the European Psyche

ICE and CCX Collaborate

Establishing ECX

ECX Moves On

The Economic Value of an Exchange

Reflections on the Success of ECX

Letting Go

Chapter 23: India

Brahmins and Katyas

Building Interest for Offsets

ICX Is Conceived

The Andhyodaya—A Chain Reaction of Innovation

Holy Cows and Sacred Forests

The Tata Motors Auction

Moving On

Chapter 24: Opening New Markets in China

First Encounter with China

Satellite Broadcasts

An Opportunity Arises

Returning to China

In Search of the Perfect Exchange Partner

A Turn of Fortune

The Birth of the Tianjin Climate Exchange

Raising TCX

The Opening of TCX

The World Is Getting Flatter!

The People’s Bank of China

A Postscript on China

Chapter 25: Good Derivatives

The Past 40 Years

Laying Out the Construct for a Good Derivative

The Next Forty Years

Chicago, My Kind of Town

Appendixes

Acronyms

Glossary

Photo Insert

Index

Additional Praise for Good Derivatives

“This book by Dr. Richard Sandor powerfully reminds us that the well-being of any economy is directly related to its ability to be innovative. Sandor, with his inventive mind, has himself helped to create new markets that have not only strengthened our economy but have also given us new ways to achieve important environmental and social goals. From his example, we learn that the creator of new markets must excel not only as an innovative thinker, but also as an effective advocate and teacher to policy makers and the general public. His life story demonstrates what one talented and committed person can accomplish in a free society.”

—David L. Boren, President, The University of Oklahoma, Longest-Serving Chair of the U.S. Senate Select Committee on Intelligence

“A fascinating story from a most eloquent storyteller. A must read for anyone interested in the complex relationship between financial innovation and low-carbon economic growth.”

—Christiana Figueres, Executive Secretary of the United Nations Framework Convention on Climate Change (UNFCCC)

“The evolution of derivatives is a fascinating tale and no one tells it better than ‘Doc’ Sandor, one of the most dynamic intellects this industry has ever seen. Starting with his early days of creating electronic trading at the University of California, Berkeley, and ranging through his leading role in the creation of financial futures and the development of a global market for emission credits, Richard spins a wonderful story that is difficult to put down. I recommend this book to anyone who is curious about capital markets and the power of innovation to transform the world.”

—John M. Damgard, President, Futures Industry Association

“Richard Sandor quotes Schopenhauer’s comment that all important truths go through stages when they are ridiculed and then opposed. Today even the existence of climate change is ridiculed by some, and serious action to cap the gases that cause it is forcefully opposed by others. Richard’s account of how the tools of modern financial markets can be turned to environmental use reminds us that there is a way forward, and the truth, founded on the laws of economics, that the environment can be saved if it can be commoditized will become regarded as self-evident.”

—Henry Derwent, President/CEO, International Emissions Trading Association

“At a time when markets around the world are struggling to find secure footings, Richard Sandor, through an artfully crafted story of his career, reminds us that financial innovation isn’t all bad and that risk entails, well, risk. Writing for both the financially literate as well as the challenged, Sandor has recapped a career that blazed new paths in financial exchanges in a readable and informative way. Not only does Good Derivatives show how derivative and financial innovations can create market value, but in the book Sandor demonstrates how careful planning, perseverance, and understanding the climate in which you operate are the keys to success. An important read for today’s policy makers.”

—Christine Todd Whitman, Former Governor, State of New Jersey

Copyright © 2012 by Richard Sandor. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Sandor, Richard L.

Good derivatives : a story of financial and environmental innovation / Richard Sandor.

p. cm.

Includes bibliographical references and index.

ISBN 978-0-470-94973-3 (hardback); ISBN 978-1-118-21636-1 (ebk); ISBN 978-1-118-21639-2 (ebk); ISBN 978-1-118-21649-1 (ebk)

1. Financial services industry—Technological innovations. 2. New products. 3. Green marketing I. Title.

HG173.S256 2012

332.64'57—dc23 2011043305

Dedicated to My Family

From top left (clockwise): My granddaughter, Justine Sandor Ludden; Ellen and I at People’s Park, Berkeley; my grandson, Elijah Sandor Ludden; my grandson, Caleb Sandor Taub; my daughter, Penya Sandor and her husband, Eric Taub; my daughter, Julie Sandor and her husband, Jack Ludden; my parents, Henry R. Sandor and Luba Mirner Sandor; my brother, Frank (left) and I, at ages 18 and 13; my grandson, Oscar Sandor Taub at a chess tournament in Atlanta; Charlie Finley and I; (center) Ellen and I on our wedding day. I was 21 years old; (center insert) Ellen and I today.

Foreword

There are some books that change our way of looking at a subject. Dr. Richard Sandor’s book is one of them.

Our modern life, with all its comfort, convenience, and freedom unimaginable to early generations, depends critically on the smooth, joint working of an intricate web of interconnecting markets, from fairs and supermarkets to commodity exchanges and financial futures. In most cases, these markets appear to work so effortlessly that many of us take their existence and operation for granted. But they are human creations.

In this book, Dr. Richard Sandor presents a personal account of how new derivative markets have come to be invented over the past few decades, a time of explosive growth of financial instruments, most of which we still poorly understand today. It is an engaging and informative tale of how markets are created.

Although economists claim to study the working of the market, in modern economics, exchange takes place without any specification of its institutional setting. When economists say that the market works, what usually comes to their mind is a diagram in which the demand schedule intersects the supply schedule, giving rise to the equilibrium point at which the price and quantity are mutually determined. The demand and supply schedules, which Alfred Marshall referred to as the two blades of the price scissors, are theoretical constructions. While we cannot conduct economic reasoning without certain basic concepts and some relevant theories, economic reasoning cannot be all and only about a theoretical world and detached from the real economy. Unfortunately, modern economics for the most part has become a theory-driven subject. I have referred to this kind of economics as blackboard economics. Economics professors can proudly and conveniently teach it to students in the classroom without obliging themselves and their students to investigate how the real economy works.

But the diagram of demand and supply schedules is too detached from reality to inform students and their professors about how the markets actually operate in the economy. In the first place, the markets do not exist automatically. When economists discuss the choice between the pricing mechanism and administrative ordering, they usually assume that the two choices are readily available, not so different from the situation in which a consumer decides which car to purchase, a Toyota or General Motors. But as Dr. Sandor shows, the creation of markets is a lengthy struggle, full of surprises and uncertainties. Dr. Sandor details the endless meetings and exhausting negotiations that he held with other entrepreneurs, lawyers, and financiers, as well as government officials and regulatory agents in the process of creating those markets. This account opens a window to the complex reality of market making in the real world. It brings to light what is really involved when economists say that the market mechanism is used in resource allocation.

Markets are social institutions that exist to reduce the cost of carrying out exchange transactions and thus facilitate exchange and the division of labor. An important source of such costs in creating new markets is convincing the potential beneficiaries as well as the regulators of the economic value of the exchange that will be facilitated by the new markets. While it is obvious that a grain market benefits both consumers and farmers, it requires far more effort and ingenuity to convince the public of the value of a market for carbon dioxide emission rights, a market for climate exchanges, or a market for interest rate futures. Early research by Dr. Sandor in the late 1960s to implement an all-electronic, demutualized exchange did not advance despite being ahead of its time both conceptually and technologically but it eventually became the prevalent model in the exchange sector. The creation of new markets is frequently complicated and sometimes even thwarted by ideological enmity, political resistance, fear of uncertainty, or mere ignorance.

As Dr. Sandor illustrates well in this book, the creation of markets is always a social enterprise. It requires the collective actions of many individuals, organizations, and government agents. As in all collective efforts, human relations matter. The market does not and cannot reduce flesh and blood people with distinct identities into machine-like atomistic agents. Market participants certainly calculate and reason; but they remain social animals. The operation of the market also requires complicated rules and structures, which in turn requires concerted efforts and planning. Rules and norms are frequently needed. Many such rules and norms are self-enforced. But the state is often involved in enacting rules and providing credible third-party enforcement. All of this is discussed in Dr. Sandor’s book.

I first met Richard Sandor many years ago when I was editor of the Journal of Law and Economics at the University of Chicago Law School. He submitted a paper on the development of a plywood futures contract. It was a most interesting article and I was very happy to publish it. Dr. Sandor was upset that the market failed because it did not attract enough customers to cover the costs. It did not upset me at all. On the contrary, it showed how difficult it was to create and maintain markets. In the years since then, Dr. Sandor has turned himself from an academic economist into a full-time entrepreneur, a market maker. In this book, he recounts how his study of economics at the University of Minnesota got him interested in economics problems in the real world. I hope this book will get more economists to leave their studies and look into the real world, without changing their careers.

Ronald Coase

Preface

The path of least resistance and least trouble is a mental rut already made. It requires troublesome work to undertake the alternation of old beliefs.

—John Dewey

I’ve always loved stories. It really doesn’t matter whether I’m listening to other people’s stories or telling my own. The best are always personal. This is my story. It’s an economist’s tale, but it isn’t dismal. It’s a story about invention and innovation. It’s about high hopes and determination. It’s about the exhilaration of initiating change. It’s also about dealing with frustration and failure. Both, after all, are inevitable in any saga on transformation. This is also a story about the spirit of Chicago, a true American city that embraced innovation and was the stage for much of my work. It is a story that spans five decades of inventive activity and institutional building in the commodity markets that saw Chicago’s LaSalle Street transform from a grain trading hub to a pioneer in financial and environmental markets. I decided to commit this fuller story to paper on June 26, 2009.

That night at 6:15 P.M., my wife, Ellen, and I attended a formal banquet hosted by Ernst & Young at the Hilton in Chicago, honoring “Entrepreneurs of the Year” in the Upper Midwest. As we sat in the hotel bar just prior to entering the ballroom for the event, Ellen’s cell phone rang. It was our daughter, Penya. Ellen listened, then turned to me with a big smile and loudly said, “It passed!”

What Ellen was referring to was the American Clean Energy and Security Act (ACES). It was a historical event for both the United States and the world. Following numerous unsuccessful attempts, the U.S. House of Representatives had passed a bill that required the country to reduce greenhouse gases contributing to global warming. It was legislation I strongly supported.

President Obama articulated three goals during the days following his inauguration: revitalize the economy, enhance U.S. military security, and develop new domestic energy sources while mitigating climate change. In my view, ACES facilitated the achievement of all three goals. First, green entrepreneurship and green jobs would help revitalize the economy. Second, the substitution of renewable energy for imported fossil fuels would begin the path toward energy independence and thus military security. Lastly, ACES would reduce energy usage, increase domestic supply, and combat global warming.

For me personally, the passage of ACES was a milestone in a long journey. The road that began at the Earth Summit in Rio de Janeiro in 1992 led me on a path toward creating financial products to reduce environmental pollution, and ultimately toward my involvement in creating the Chicago Climate Exchange. That night, I was elated that the United States was taking a leadership role in solving the most important environmental objective of our time. It was a moment of personal vindication.

We were seated next to Sadhu Johnston, one of the judges for the evening and chief environmental adviser to Chicago mayor Richard M. Daley. I mentioned to Sadhu that the evening was momentous for yet another reason: it was the eve of our forty-sixth wedding anniversary.

The event was staged like the Academy Awards, with eight award categories ranging from financial services to technology. Chairmen and CEOs from both public and private companies dotted the stage. A one-minute video on each nominee was broadcast onto two large screens. Terry Duffy and Craig Donahue from the Chicago Mercantile Exchange were the first winners, awarded for having transformed a mutual floor trading exchange into the largest publicly traded electronic futures exchange in the United States. I had served numerous terms on the board of directors of both the Chicago Board of Trade and the Chicago Mercantile Exchange, and knew both men well. I was delighted to see them recognized for their achievements.

About three-fourths of the way into the ceremony, Sadhu leaned over to tell me that I was next. He told me the video was four minutes long, not the one-minute version reserved for other categories. He joked that there was more to say about me. Personally, I suspected that the longer length was more due to a new interest in sustainability and not my work, per se. The video began with my first job as an assistant professor at the University of California at Berkeley. The photograph of a young man with very long sideburns was a bit comical and reflected the tastes of the 1960s. The nostalgia had begun. The video proceeded to describe my role as the principal architect of interest rate futures and the universal recognition afforded to me as the “father of financial futures.”1 My work in emissions trading came next, along with the role of markets in combating and virtually eradicating the acid rain problem in the United States. It concluded with highlights from the history of the Chicago Climate Exchange and its efforts to deal with global warming in the United States, Europe, China, and other parts of the world.

The award set my mind whirling with images of the people who had shaped and influenced my life. The award didn’t just signify individual achievement, as inventive activity was often collaborative and I had the good fortune of living in the right time and being in the right place. That evening, I resolved to write this book.

This is a story of financial innovation. For the most part, innovation is respected and valued. Yet as I record my own story, there is a cloud over financial innovation. As America continues its struggle to regain its economic footing, financial innovation has been widely blamed for causing the 2008 global financial meltdown. Critics are not always well versed in economics and finance. But even sophisticated observers share this view. During the financial crisis, Chairman of the Federal Reserve Bank, Paul A. Volcker, remarked that the only valuable financial innovation in the past twenty years has been the automatic teller machine. He went on to say, “I wish someone would give me one shred of neutral evidence that financial innovation leads to economic growth. One shred of evidence.”2

I believe that there is more than one shred of evidence. It may have gone unnoticed since much of the positive financial innovation of the past four decades emanated not from Wall Street, but from LaSalle Street—home to the Chicago Board of Trade, the Chicago Mercantile Exchange, and the Chicago Board Options Exchange. The Chicago exchanges, traditionally the trading arena of agricultural products, revolutionized global finance by developing and popularizing financial futures and options.

Perhaps it was their comfort with the concept of managing risk that made Chicago exchanges more willing to experiment with new financial instruments. Perhaps it was the notion of being second, and wanting to unseat the guy at the top, that has left the leaders of these exchanges hungry to try new approaches. This is not to say that the business transacted on these exchanges was small. In 1970, Chicago was flexing its big shoulders. That year’s annual report of the Chicago Board of Trade proclaimed:

The year 1970 might well be recorded in CBT annals as the “year of the markets.” Trading activity at the Board set an all-time record as more than 8.1 million contracts were traded during the year. This was 500,000 more than the previous record of 7.6 million contracts, set in 1966. The estimated dollar volume of these contracts soared to $73.3 billion, an increase of 96 percent over year-earlier levels. During July, August, and September, our estimated dollar volume exceeded that of the NYSE; a fact worthy of particular note, since the NYSE continues to be the only financial institution in the world larger than ours.3

Still, Chicago commodities exchanges were always seen as niche markets, the province of agricultural regulators and of interest to far fewer people than the Dow Jones Industrial Average or the New York Stock Exchange.

But it was the Chicago Board Options Exchange, and not the Big Board in New York, that provided a home for trading in stock options in 1973. In 1975, it was the Chicago Board of Trade that introduced interest rate futures. This allowed financial institutions to hedge or cushion their risk against interest rate swings. Similarly, stock index futures originated in Kansas City and were commercialized by the Chicago Mercantile Exchange. The same pattern applies to currency futures.

So while Volcker’s discomfort with financial innovation may have been understandable, his nihilistic attitude stunned me. Innovation has helped make the American economy what it is. The economist Robert Solow won a Nobel Prize in Economics for demonstrating more than 40 years ago that the well-being of an economy is tied, in part, to its ability to innovate. More than 30 years ago, Kenneth Arrow, another Nobel laureate in economics, observed that financial innovations, such as the limited liability corporation and double entry bookkeeping, may have been just as important to economic development as technological innovations like the steam engine or semiconductor. Yet such financial innovations are often overlooked for at least three reasons. First, they are intangible and may be difficult to understand by laypeople. Second, they tend to be wholesale, that is, they are not part of the retail mass market. And third, until recently, they were not patentable and their benefits accrued only to first movers.

In the late 1970s and early 1980s, while Volcker was battling a pronounced upsurge in inflation and interest rates, Chicago’s new interest rate futures contracts undoubtedly helped banks and other financial institutions protect themselves as interest rates shot up. While some of the risky strategies that firms like Lehman Brothers used in the hopes of making giant profits were clearly rash and ill informed—within the firm and externally—such examples should in no way stand as a blanket indictment against financial innovation. Documentaries like The Inside Job criticized financial maneuvering for causing the 2008 financial crisis, but failed to properly distinguish between markets that are transparent and regulated and over-the-counter markets that are opaque and unregulated.

One of my goals in writing this book is to shed more light on the process of financial innovation, and the careful thought that went into the innovations that I helped shape in Chicago. This book provides a description of my early life, starting with my childhood in Brooklyn as the son and grandson of immigrants. I move on to my graduate studies in Minnesota, and through my stint as a young professor in Berkeley. Next is my failed attempt at starting a totally electronic exchange in the 1960s, and my migration to the fast-paced commodities markets in Chicago. From there, I move on to the innovations themselves: mortgage interest rate futures contracts, Treasury bond futures, options on Treasury bond futures, Treasury note futures, environmental derivatives, and the birth of the Chicago Climate Exchange. Every innovation has its own unique story. Throughout my book, I try to explain how each new financial product came about, its intended purpose, and the economic, political, and financial ramifications. Technical explanations are provided for those interested in gaining a more in-depth understanding of these products. I also emphasize the importance of selling an idea, having discovered early on that simply creating a new product is not enough. New financial products are sold, not bought.

Good Derivatives, those listed on regulated exchanges, create value for society and prevent systemic breakdown of financial institutions and capital markets. These markets create value by providing a mechanism for corporations and financial institutions to hedge against price risks in commodities, stocks, and bonds. They also allow us to discover market-based forecasts of future prices. The transparency of futures prices on regulated exchanges results in lower transaction costs for the purchase or sale of commodities, stocks, and bonds for the spot, or immediate delivery market.

Good Derivatives are financial innovations that are created and can’t be assumed to exist. Economists generally imagine, conjure, or assume the existence of markets. Furthermore, they often assume that markets function efficiently. While these assumptions may be effective for teaching and developing theories, they overlook a critical part of economics: the creation of the market themselves. In reality, establishing a viable market involves a great deal of hard work, expense, and marketing to potential users. It involves building layers of institutional capacity that can support and nurture young markets. It involves getting the right combination of new legislation, regulation, and compliance to ensure trust in the markets, exchanges, and/or standardized contracts.

I believe that the recent collapses of financial institutions and the banking system could have been avoided if financial innovation—be it CDSs,4 subprime mortgages, or CDOs—had followed the path of innovations described in this book. This is a story about good derivatives that were created in the past 40 years. There were no regulated and transparent futures and options exchanges that required a bailout by governments during the great recession. Good derivatives performed flawlessly.

The value of financial innovation can only be realized if the costs of establishing and operating a market do not exceed the benefits. Markets that minimize transaction costs are designed to do so. They too do not simply exist. Ronald Coase, a Nobel Prize–winning economist, taught us that if we view economics through this lens, we can come closer to understanding the nature of organizations and markets.

This is a story about good derivatives that were created in the last 40 years. It is my hope that it will be useful to financial innovators, regulators, and policy makers in America and around the world. This is also a story about the future. I hope it will be of value in predicting new geographies and new financial innovations that occur in the next 40 years.

Richard Sandor

September 21, 2011

Wrigley Building, Chicago, Illinois

1 Resolution by the City of Chicago, honoring Richard L. Sandor, August 12, 1992.

2Wall Street Journal’s Future of Finance Initiative, December 8, 2009, http://blogs.wsj.com/marketbeat/2009/12/08/volcker-praises-the-atm-blasts-finance-execs-experts/.

3Annual Report, Chicago Board of Trade, 1970.

4 A credit default swap (CDS) is a swap designed to transfer the credit exposure of fixed income products between parties.

Acknowledgments

As I pen these acknowledgments, I want to foremost thank the man who urged me to write this book and advised me to just tell the story. Ronald Coase has personally inspired and mentored me for the past four decades. My gratitude toward him cannot be described. I have been visiting Professor Coase for many years, before and during the time this book was being written. We often discussed the book over lunch and he gave me invaluable advice. He possessed the clarity common to great teachers. When I finished the first half of the book, I nervously handed him the manuscript like a student completing an exam. I came back two weeks later and asked him what he thought of it. After complimenting me on my achievement, he added, in a soft English accent, “It’s one damn thing after another.” His words meant a lot to me. I was finally telling the story he asked me to tell. The process of financial innovation was—and is—one damn thing after another. And I wouldn’t have it any other way.

I have long since discovered the flaws of human memory. Thankfully, there were many friends who helped me recount the events captured in this book. Natalie Persky, Tom Cushing, Mike Walsh, Mike MacGregor, Rob McAndrew, Rohan Ma, Jeff Huang, Fran Kenck, Ann Cresce and Kathy Lynn Minervino-Myers all delivered colorful personal accounts of what took place in the past decade. Neil Eckert, Helene Crook, Peter Koster, Sara Stahl, and Albert DeHaan generously shared their memories of the creation of the European Climate Exchange with me. Tony Chiarenza, Joe Cole, and Ed Berko’s recollections of the 1990s helped me convey the exciting possibilities of insurance derivatives during that time. Ricardo Cordero provided me with an accurate history of electronic trading in Europe that was also rich in astute personal observations. Al Swimmer, Jay Feuerstein, Norman Mains, Jérôme de Bontin and Rick Ferina all related their experiences of the 1980s to me. Their conversation was enthralling, and I regret that not all of it could be incorporated into this book. My former colleagues, Chris Andersen, Peter Ackerman, and Syl Schefler, also shared stories about how capital markets helped finance entrepreneurs in the 1980s. Lou Margolis described the birth of indexing in the equity markets while Jay Pomrenze helped me understand how early adopters used financial futures. Michael Spencer, a former colleague and now the CEO of ICAP, the world’s premier interdealer broker, gave me invaluable insight into that sector of the business. Michael has always been a good friend and supportive of my efforts. Philip McBride Johnson inspired me with an adventurous account of how he crafted the language that enabled the birth of financial futures. Jon Goldstein, my friend of almost five decades, recapped the wonderful memories of our years at the University of Minnesota. Many thanks to my brother, Frank, my nephew, David, and my cousins, Ruth and Jocelyn, who reminded me of many stories of our family and childhood.

I also tapped the knowledge of members of Chicago’s futures community. I am thankful to Bill Brodsky, Jack Sandner, Rick Kilcollin, Scott Gordon, Tom Donovan, Larry Rosenberg, Frank Jones, Lee Stern, David Goldberg, Joe Gressel, Pat Hennessy, Don Wilson, and Nathan Laurell. Galen Burghardt revived memories of the early seminars we conducted to educate users of financial futures. Ken Raisler gave me an expert’s insights into the regulatory process in the futures industry. A special thanks to John Lothian, who provides a valuable service of disseminating news and commentary on the futures industry from Chicago to the world. His support over the years has been important to me. My friend and mentor, Les Rosenthal, was, as always, a source of inspiration and fond memories.

Without the advice and dedication of investment bankers Paul Hodges and Jim Durkin, we would have never been able to finance the largest carbon market in the world today. Neil Woodford, an early and committed believer in our concept, deserves the same if not greater credit. They are the unsung heroes of European emissions trading.

As with any book that deals with finance, reliable data and facts are critical. For their promptness and patience with my requests I am grateful to Gil Avidar, Chris Bartlett, Greg Busler, Nicole Cook, John Fyfe, Tom Gibson, Steve McComb, Dan Scarbrough, and Andy Totman. Will Acworth and Toby Taylor at the Futures Industry Association were terrific. Thank you to Charlie Carey and Lindsay Phillips at the Chicago Mercantile Exchange, the Intercontinental Exchange, and the Joyce Foundation for kindly sharing and allowing us to use many important materials in this book.

Eric Chow, Alice Xie, and Kwangun Lee meticulously organized the daunting pile of information files we’ve accumulated over a decade and did research. Fang-Yu Liang, and Daphne Yin performed excellent research and were exemplary as editors. They were all seamlessly managed by Rafael Marques. In fact, I couldn’t have written this book without his help. His feedback and editorial contribution to the entire manuscript were crucial. Thanks also to my colleagues, Murali Kanakasabai and Nathan Clark, for reading, editing, and harshly critiquing the manuscript. I cherish Nathan’s sometimes near-brutal honesty and embrace Murali’s vigor for always challenging me intellectually. Both were crucial to the integrity of the end product. A special thanks to my assistants, Mary Ann White and Melanie Rakovic, who were invaluable throughout this process.

I also need to thank Karen Arenson, Victoria Rowan, Margery Mandell, Emily Lambert, and Andrew Szanton for their help in the early chapters and the advice they gave me on writing. Dan Yergin gave me an invaluable piece of advice: to start the story at a point where my comfort level was high. It didn’t have to be at the beginning. He was given this advice by one of his mentors, and it served him well. It served me well, too.

A special thanks to Joyce Gladstone Silver and Martin Greenberg for keeping memories of P.S. 99 and Midwood High School vivid and alive.

This is a unique book—a hybrid of a memoir and a financial and economics text. At times, the two themes complemented one another, and at times, they conflicted. This was a source of constant challenge for me. Fortunately I relied on some of my trusted friends and former colleagues to review parts of the manuscript. I am grateful to Paula DiPerna, Carole Brookins, Sylvie Bouriaux, Keith and Arlene Bronstein, Chris Culp, and Ning Wang. Their insights, edits, suggestions, and criticisms were priceless. As friends, they went above and beyond what I asked of them. I would also like to thank John Beasley, who gave me a terrific suggestion for one of the chapter titles on the Chicago Climate Exchange.

I am grateful to my executive editor, Kevin Commins at John Wiley & Sons, for approaching me with the proposal to write a book about my work as an inventor of “good derivatives.” Other members of the Wiley team, like Meg Freeborn and Melissa Lopez, were also instrumental in guiding me through the manuscript production process.

As with any other book, the acknowledgment section has often been, and should be, a place to express one’s true feelings of gratitude toward one’s family. My daughter Penya advised me to write the book I would like to read. My daughter Julie told me to write it as if I was teaching, and Ellen, an artist at heart, prodded me to “follow my instincts.” She patiently read and re-read each draft and her comments were uniquely valuable. Ellen is a loving and very wise woman. I owe her thanks not only for this book, but for a lifetime. Ellen, my daughters, their husbands, Jack Ludden and Eric Taub, and my grandchildren, Elijah Sandor Ludden, Justine Sandor Ludden, Caleb Sandor Taub, and Oscar Sandor Taub, always did, and still do, provide me with all that one would want from a family. I offer a heartfelt thank you to each and every one of them.

Chapter 1

The Early Years

America is another name for opportunity.

—Ralph Emerson

I grew up in Brooklyn, New York, in the 1940s and 1950s, with a father who loved vaudeville and movies, and a mother whose memories of her wealthy upbringing in Europe dominated our home.

The House of Sandor and Mirner

My father, Henry R. Sandor, was dark-haired, olive-skinned, and heavy-set. A pharmacist by day, Henry worked six days a week from 10 in the morning until 10 at night, and came home well after I went to bed. The summer of 1950, when I was almost nine, he taught me how to make ice cream sodas and malted milkshakes at his store in Brighton Beach. The store was often filled with my father’s friends from show business, and I loved going to work every day. He measured his ingredients with precision as he ground medicines in his mortar and pestle, readying them to be put into capsules. It was wonderful watching him. A side effect from my summer job was a gain of 10 pounds, and it wasn’t until my junior year in college that I stopped being overweight. My father used to say that I had personality, and that it was almost as important as brains when it came to success. I felt his love and respect.

My father often told stories about his own father and grandfather. His father, Maurice Sandor, was a dapper and handsome man. He was going to be hung for anarchy at the ripe old age of 16 for conspiring with Leon Trotsky to overthrow the Czar. Maurice’s father, however, was the chief engineer for the Trans-Siberian Railroad, and through political connections at the court of the Czar, was able to arrange to have him leave for America that very day. Trotsky wrote letters to my grandfather, asking him to return to Russia, and came to the pharmacy to play chess when he visited New York. We never really knew what was fact or fable. Maurice, according to Ellis Island records, did not, in fact, sail to this country in steerage. He spoke no English when he landed in New York, survived by selling apples on Hester Street, and within 10 years earned a pharmacy degree from Columbia University and an MD degree from New York University. Before long, Dr. Maurice Sandor owned and ran a drugstore and practiced medicine. He met Frances Diamond, my grandmother, on the Atlantic crossing. Frances came from a family of performers—her cousin, Selma Diamond, was a comedienne.

While my father profoundly respected education and spoke proudly of his father’s degrees, he was more of a Bohemian than an intellectual. He had two particular quirks. I have the fondest memories of the different hats he would wear on whim, ranging from berets to fedoras. He also had a passion for cars. Most cars on our streets were Buicks or Chevrolets, but not ours. Henry drove foreign cars—mostly Jaguars and Volvos. There was an occasional American car like the Nash Rambler.

Known as “Broadway Hank,” my father was a quiet person unless he was standing before an audience. He had a giant personality when he performed. An entertainer at heart, he loved stand-up comedy, singing, and playing the guitar. He received an offer to play in a big band in the 1920s but had to turn it down. His father had died at an early age, and he had to help raise and support his brother and sisters. He worked as a pharmacist to accomplish this and put his career as an entertainer on hold. His brother worked side by side with him at the drugstore. Two of his sisters went to Hunter College and became teachers, while his youngest sister became a housewife. My father’s brothers and sisters led typical middle class lives, working hard and placing a strong emphasis on education. The next generation of Sandors, following my father’s generation, produced two doctors, three dentists, one psychologist, one economist, and a teacher.

My memories of growing up were not dominated by my father’s profession, but more by the Bohemian lives of the people who traipsed through our house from time to time. I remember the first time I saw my father entertain. My brother, Frank, and I hid behind a chair in our house as Broadway Hank charmed everybody at the party with his humor and songs. My mother kept on coming out with food, and my piano teacher played the piano and they all sang late into the night. Her father was the lead violinist in the Moscow Symphony, and she herself was an attractive woman with a sassy attitude—there were often many allusions to sex in the adults’ conversions that I heard but never understood. I fell asleep that night to the sounds of song and laughter.

I loved Sundays. It was the only day of the week my father was home. He slept late and woke up to a sumptuous breakfast prepared by my mother. Sunday was also a day of rituals. We would all jump into a car and drive to Manhattan. We went to double features in one of the many movie theatres in and around Times Square. One memorable Sunday, we went to the RKO Palace for a double feature with 10 acts of vaudeville between two movies. Another wonderful memory is attending my first Broadway show starring Paul Muni, a famous movie actor of the day and a friend of my father’s. Paul captivated audiences in Scarface and The Story of Louis Pasteur. I felt a surge of pride that there, standing on stage, was my father’s friend. After movies, we frequented Chinatown. Henry had a great nose for restaurants and a small joint, Hong Fat Company at 69 Mott Street, became our regular stop. Unlike the many chop suey restaurants that dotted Brooklyn, that one was actually authentic.

On other Sundays, we frequented a Chinese restaurant owned by my father’s friend Tom Kwan. The restaurant was on the second floor of a two-story building. We sat in the kitchen for hours and watched Tom at work, tasting the pork and duck as he cut the meat and prepared the dishes with amazing precision. He often barked commands in Chinese to his Alaskan husky, whereupon the dog sat down or trotted away. It turned out that the dog understood not only Chinese, but also English. I was awed by that bilingual dog. I wondered, “How could a dog understand Chinese?”

My father first got to know Tom during the Roaring Twenties. Broadway Hank was performing in a speakeasy when Tom, a regular, stopped by one night wearing a lot of gold jewelry. My father noticed some local gangsters eyeing Tom, so he offered to store Tom’s valuables until the next time he came back. Tom did this without any sign of distrust or suspicion. My father also had him keep a small amount of cash handy, in case Tom needed to placate any thieves. Sure enough, Tom was mugged as he left. My father returned his valuables the next day and from then on, Tom visited our house every couple of years at some unexpected time during the Christmas season with bags of Chinese sausages, pork, and duck in tow. He sometimes even brought a large wok to cook food. I sat for hours watching him cook. The meal always ended with a big Christmas fruitcake.

At some point, Tom stopped showing up—in fact, he didn’t come for three consecutive years. He had always kept his personal life to himself, and my dad never knew where to contact him. I asked my father why we hadn’t seen him. My father said in a matter-of-fact way, “Tom always comes. He must have died.” It turned out that Tom had closed his restaurant and retired. Those wonderful days spent in Tom’s company taught me a lot about Chinese culture and loyalty—something that would prove invaluable later in life during my visits to China.

On the opposite side of Tom’s restaurant was Nathan’s Famous—the largest seller of hot dogs and hamburgers in Coney Island and a big threat to the smaller hot dog vendors. According to my father, competitors once spread word that Nathan’s food was unsafe. To recover his business, Nathan went to the local hospital and announced that any doctor or nurse who came in uniform would get a free meal. When locals and tourists saw so many white-uniformed professionals eating there, they stopped paying attention to the rumors of a dirty restaurant with unsafe food. The importance of perception and promotion was a life lesson that stayed with me.

Just as my father was the patriarch of his family, my mother was the matriarch of her family. My mother, Luba Mirner Sandor, was born in Poland in a city that ultimately became Russian. Luba was a petite, shapely brunette quick to smile. Her father, David, had changed his name from Berenson to Mirner for some unknown reason, and then migrated to Antwerp, Belgium, to become a successful diamond merchant. Family lore was that he was a cousin to Bernard Berenson, the preeminent art critic. I personally never knew what was fact or fancy. David Mirner became a member of the Diamond Bourse. He was recognized in Belgium for his charity and was reportedly one of the great chess players in the country. He lost his fortune investing in a diamond mine in South Africa and from his frequent visits to Monte Carlo. He and my grandmother, Penya Mirner, along with my mother, her sister, and two brothers, came to the United States penniless. My mother’s sister had Tourette’s syndrome and could not work. Her brothers got married and were partners in a dry-cleaning business together. Education was a critical part of the Mirner family’s values. The third generation of Mirners became chemists, musicians, and teachers.

All of the Mirners seemed to have settled into normal middle-class lives when things changed. My uncle Joe fell in love with a neighbor’s wife and left home. He moved into my room shortly after my brother moved into our basement apartment. My dreams of finally having my own room were dashed. Joe was an elegant dresser and articulate man with a small moustache, whose dress and demeanor reflected his European upbringing. To avoid World War I, David Mirner moved the family to London. All the children were sent to boarding school there and in Switzerland. Joe’s life in boarding school in England had left him adept at the art of conversation, and he was a wonderful companion. He also had a great sense of humor. His companion was a stylish woman many years his junior. Joe lived with us for a short time, only to have a fatal heart attack shortly after moving in with his companion.

My uncle Charlie, a kind man with boundless empathy for others, was the next to move into my room. He later dated Uncle Joe’s companion, in what others would at best call an odd set of circumstances.

My mother, Luba, had absorbed all that a privileged lifestyle enabled. She was a woman of boundless energy, fluent in five languages. While my father was not talkative when not performing, my mother was naturally outgoing and gregarious. She was filled with strong beliefs and passionate about every activity she participated in. According to my brother and me, she was “America’s Sweetheart.” My mother shared her father’s business skills and later in life became manager of a chain of women’s clothing stores. Although frustrated by not being afforded the opportunity to go into business and somewhat bitter about not receiving the things in life she thought she richly deserved, she gradually came to terms with the circumstances and genuinely enjoyed life.

Five years older than me, my brother, Frank, had been difficult as a child with learning disabilities, so Luba hadn’t wanted any more children. As she later told me, “You were unplanned.” We didn’t know it at the time, but he was dyslexic. Frank was much too old to be a companion to me, and my mother was always helping him work through his learning challenges. As a result, she was often not available for me. Frank was deeply loved and grew up as a generous human always concerned with others. He had a red Radio Flyer wagon that he was happy to give up when he learned that the war effort required iron—certainly an incredible sacrifice for an eight-year-old child. I understood his nobility but sorely missed that wagon. Frank went to medical school and later became a hematologist. He was and is a caregiver.

Given my father’s work schedule, my mother’s justifiable attentiveness toward my brother, and the age difference between Frank and me, I grew up often feeling alone in my own home. My mother’s eyes lit up whenever my brother walked into a room. They never lit up for me, but I was determined to make that different outside of our home. For as long as I can remember, friends became an important part of my life. By the time I was six years old, my mother began giving me an allowance of 25 cents per week. I would use 15 cents for a movie and candy, and my mother often asked me about the movie when I came back. She and the neighbors used to listen attentively as I faithfully described the plot and the characters. Their positive feedback only increased my desire to see more movies and tell people about them. This was further enhanced by the Sunday ritual of my father taking us out to movies. Movies were not only entertainment, but became a means to learn about life. I came to enjoy them as much as I did reading.

Bobby Fischer and My Days at School

Friendship helped combat the isolation I felt on most days. Public School 99 (“P.S. 99”) provided all that I needed in kindergarten through third grade. School was easy, and I had plenty of friends. My world was shattered when my mother announced that we had bought a house and were moving. I began fourth grade at a new school with a great deal of apprehension. I soon learned that I had been put in class 4-5, which in those days meant that I would be among the slowest students in the fourth grade as well as those who were troubled and had behavioral problems. 4-1 was reserved for the brightest students. As the year went by, I was forced to get along with classmates who were very different from those in my earlier grades, which actually turned out to be a wonderful learning experience. After several months, the teacher recognized how quickly I was learning and responded accordingly. She started to treat me more like an assistant than a student, and I helped her prepare lesson plans and pointed out how she could reach some of the other students. Teaching thrilled me. In some ways, these days turned out to be some of the happiest days of my childhood. At the end of the year, my teacher told me that I had “made her year” and recommended that I be transferred to 5-1. I came back later on to see her as I grew up, and it always thrilled us both to speak about my year there.

Meanwhile, I made friends with Robert Friedman, who was a year younger than me. We played stickball, softball, and cards together and ultimately taught ourselves how to play chess, another driver in my life. We met Raymond Sussman, who lived in the neighborhood. He easily beat both of us in chess. His father, Dr. Harold Sussman, a nationally ranked player and dentist from Brooklyn who played in the Manhattan Chess Club, taught us strategies such as sacrificing pieces for positions known as gambits and how to think about chess in terms of opening, middle, and end games. He emphasized the importance of controlling the central four squares on the board, a life lesson for business and politics.

One day, out of nowhere, a boy a year or two our junior passionately pleaded to be included in Dr. Sussman’s classes. His name was Bobby Fischer. We played blitz chess—one second per move—and initially Bobby was rattled. He went away and came back more polished and in each game became harder to beat. The last time we played together, he came back to play in a tournament organized by Dr. Sussman. Robert had eliminated him in an early round, and we were faced off for the final match. I won a closely contested game. The next thing we heard from Dr. Sussman was that Bobby had been studying chess from five in the morning until school began and then from the time school ended until he went to sleep. He wanted a rematch with both of us. We declined. And that’s how Robert Friedman and I managed to have a lifetime winning record against the one and only Bobby Fischer.

Fifth grade was harder. I was the new kid in class and had to make a new set of friends. As the next two years went by, I became bored and often misbehaved. My sixth-grade teacher was a martinet and berated me in public for my behavior until I became silent and refused to answer any of her questions. Eventually, she found a solution by assigning me to the principal’s office to prepare tests and outlines for teachers. I learned how to type, a skill that proved invaluable, and relished the hours outside the classroom. Before long, I went to junior high at yet another new school. The experiences, feelings, and challenges resembled those I had gone through in grade school.

A friend of my father’s found a job for my brother as a counselor in a summer camp in the Berkshire Mountains and I was sent along as a camper. As it turned out, one of my classmates from junior high school had poisoned the well for me and made it hard for me to make friends. I was miserable and wanted to go home after the first week. My parents told me that I had to stay.

To escape reality, I often listened to an old radio with static. The static annoyed the other campers and in an effort to placate them, I one day started screaming at the radio and shaking it. My fellow campers started to laugh as I went through a 10-minute routine about how bad the radio was and ultimately smashed it on the floor, creating an uproar of laughter. It was the beginning of my role as the camp comedian, and I became adept at finding humor wherever it existed. We had variety nights when I was urged by all to do a standup routine for 15 minutes. Years of watching my father finally gave me a chance to learn how to deal with an audience. I was a good mimic, and while I had experimented with humor sporadically with friends, I had never performed onstage. Yet it all came together, and from then on I became accustomed to providing comic relief to campers and counselors alike. I did my standup routine for the next three years and at one time actually thought it might become my career. I was not the only comic at Camp Pontiac. Another camp comedian, Larry Brezner, and I spent time together sharing jokes. We lost touch over the years but I had fond memories of him. He later went on to Hollywood and co-produced the original version of the film Arthur and Good Morning, Vietnam.

After my first summer at camp, I advanced to the ninth grade at a new high school. My breakthrough with comedy at camp helped me win new friends even though I was short, fat, and at 14, a year younger than other sophomores. Midwood High School, also attended by Woody Allen, became a dream come true. I was elected president of the student council, which consisted of the presidents of the junior and senior classes. I loved the student government, although I ran for mayor and lost. I naively thought that good ideas and effective communication were all that was required, and didn’t realize until too late that politics also required alliances and organization. Those days prepared me for a life that would often revolve around election politics at exchanges.

Classwork was moderately challenging, and I did reasonably well while maintaining an active social life. In fact, my parents constantly prodded me to do better. They thought me lazy as I spent most of my time with friends or in front of the television. While I frequented movies and played poker on weekends, Frank worked endlessly to overcome his learning challenges and set the standard for dedication and hard work. He performed well and followed my father and grandfather to study pharmacy at Columbia. My father wanted him to enter the pharmacy business but soon realized that it did not really suit him. Frank went on to study art and obtained a master’s degree at New York University, all in preparation for medical school.

Discovering Economics in Brooklyn