Investing in the Dark

Sydney-based Satyajit Das, a global expert on hedge funds, says derivative products are “the glue” that holds modern financial markets together. Yet relatively few people really understand how derivative markets actually work.

In other words the vast majority of investors have no idea how derivatives operate and that means they're breaking a cardinal rule of finance: always understand your investments.

If you think the observations of this author and former trader are irrelevant, remember that the major banks are a pillar of almost every private investor's portfolio and derivative trading has become an increasingly important element of banking revenue. Moreover, the recent NAB forex scandal showed that too few people inside the bank '” not to mention retail investors '” understood what was happening in the trading room.

As Das points out, the irony for retail investors is that institutions feel compelled to “package” derivative products for the retail market while restricting relatively simplified products to institutional clients. As a result, private investors are only offered what Das describes as the “riskier layers” in derivatives. Typifying this outcome is the recent success of CDOs (collaterised debt obligations). As a former treasurer at TNT Australia and a derivatives director of Merrill Lynch, Das has an exceptional grasp of the Australian hedge fund market.

The interview

Michael Pascoe: Your book '¦ should we be scared, having read it?

Satyajit Das: Well, think the key thing about my book Traders, Guns and Money: Knowns and Unknowns in the Dazzling World of Derivatives, is the knowns and unknowns. I think one of the key things is that everybody directly or indirectly is exposed to the derivatives world and these are complex instruments which re-arrange risk in very interesting ways, and people do it essentially to try to get higher returns. The problem is: I always wonder do they actually understand the risks fully and if you don’t understand the risks, don’t understand what you’re buying, then I would be afraid.

We now have a financial system though that is floating on derivatives.

It is. It’s actually a remarkable thing that in the past 30 years, from the birth of derivatives, we now have a market that totals over $US250 trillion '” and a trillion, as you know, is a million million. Goldman Sachs alone has over about a $US1 trillion worth of derivatives exposure on its balance sheet and, most importantly, it’s now almost the glue which holds the financial systems together. There are things, like, for instance, the returns that investors get '¦ profits that banks make. Everything is driven by derivatives.

You’ve played both sides of this game, both in the trading rooms of major banks and as the treasurer of a major corporate. What you’re saying is most people playing the game don’t know how it works.

I think that’s probably a reasonably correct assumption. I think in the world there’s probably no more than a few thousand people who really know the rules of the game. And I think the key thing is that unless you understand the rules of the game well enough it’s not easy to play in this pool, and in the end there is a net transfer of money from those who don’t know to those who know how the game is played.

You’re saying traders lie. Their bosses lie. Their boss’s bosses don’t know what’s going on and they still buy?

Well, I think it’s a huge problem of what I call information asymmetry and it occurs at two levels. One level is within the banks themselves '” only the traders and very few people know what’s really going on. Their bosses, as you say the risk managers and so forth depending on how good they are, may or may not know what’s really going on. I mean, I’ll give you an example. The NAB has very large risk-management departments and compliance departments, yet they seem to have failed in terms of detection of the problems there. So I think there are very few people who are qualified and I think the information asymmetry also extends between banks on the one side and their clients; and I think this makes life very awkward for everybody.

Retail level investors might be thinking, 'Well look, this is game for major banks, nothing to do with me’, but retail investors have been marketed quite a lot of products that are based on derivatives.

I think it’s absolutely one of the most fascinating things about the derivatives market. If you go back 20 years it was really, as you say, a game played by the big boys. What has happened over the past 10 years is that this has all become retail-oriented products and I think one of the interesting things is the banks have done it because essentially the profit margins are bigger and on the other side, the clients have looked for higher returns as returns have gotten squeezed, as interest rates came down. One of the most remarkable things is the more complex the product the more sophisticated it is, the more likely it is to be a retail product.

For example?

Well, one of the big products that had been sold in Australia as in other markets is what we call CDOs, collateralised debt obligations. What it takes is, you take a portfolio of credit risk, which might be a 100 names, and usually in Australia they are overseas names. Then what we do is we put them into a portfolio and then basically sell them off, but not in their entirety but different people take different layers of risk so we so we have what we call the equity risk layer, which is the first loss. So you really take only the first two or three losses that might occur on the spot folio.

You might buy what we call mezzanine or junior mezzanine. You might take the next four or five, so if you’re a retail investor who’s bought one of these you’re really looking at this 100 portfolio but you’re really betting on only three or four names and also that’s what we call realised losses. That’s if there’s actual defaults. However, you may want to liquefy your investment, sell it before maturity. The actual value for your investment, if you sell it before maturity, will depend on quite complex mathematical models, which will look at how the relative risks have changed and what we call default correlation. In other words, if A defaults, how likely is it B is going to default? All of this is difficult to measure and difficult to model and you need 40 PhDs running around with super computers to do that. I don’t think many houses in Lidcombe are equipped for that.

Are the people offering those products, the big name banks, investment banks, are they equipped for it? Do you have faith in those products?

To be fair, the best players are equipped for it but they themselves know that their models have flaws. I mean one of the nice things about models is by definition a model is a representation of something, it’s not the real thing and to be honest, some of these models have not been severely tested in the market downturn or in a crisis. So to some extent the big banks understand this and they hold substantial reserves against it, but at the end of the day they’re just their estimates of what the worst case can be.

We don’t know what the real results will be and the problem also is because the market is very concentrated with very few banks dominating these types of products that if there is a problem then it will have quite significant problems in terms of just liquidity in the market which will exacerbate the losses.

Do you have any CDOs in your portfolio?

No, I don’t own any CDOs but if I did I wouldn’t be owning the mezzanine and the equity part. I would be owning what’s known as the senior piece, which is triple A rated; and then we have a piece which is actually called super senior which is better than triple A '¦ better than sex, somebody once said.

But that’s not what’s being marketed to the average retail investor?

No, but the interesting thing about the retail investors is, there are some people who’ve bought those types of pieces of the paper but the vast majority of them are looking for higher returns and the higher return as we all know, are related to risk. So in fact the riskier layers are going to retail.

You haven’t written a textbook. Traders, Guns and Money is a good read. Is it nonetheless capable of scaring people?

I wanted to do a couple of things with this book. There is no accessible literature to somebody other than the specialists. I wanted to make sure that there was something, that somebody at the peripheries of the business, somebody interested in the business, could pick up, read and read it at two levels. Once to understand, so get some information about what really goes on, but also have a good laugh because I think you learn a lot when you laugh. But at the end of it I hope people come away a little bit better informed and more knowledgeable and make better investment choices.