Sandor talks about inventing markets

January 12, 2014 10:49 AM
Blog first appeared in DanCollinsReport on Aug. 6, 2013

Richard (Doc) Sandor has been described as brilliant by many but from my perspective his genius is in being able to see the essence of things; understanding the simple purpose of a product and applying it free from any preconceived parameters.

Sandor, who created the first interest rates futures in the 1970s and later a market for carbon  emissions, envisioned interest rate futures because he understood the basic purpose of futures and saw a need. He was free to look for industries and elements in the world that carried risk and looked to invent markets that would allow that risk to be hedged.

Sandor headlined a stellar group of industry professionals on the final day of the Marketswiki World of Opportunity Summer Intern Education Series, put on by John J. Lothian & Company.

Sandor talked about what was needed to create or invent (his preferred word) new markets.

He noted that back in 1970, when he first began contemplating interest rates futures, annual futures volume was 13.7 million contracts, by 2010 that had grown to 23.1 billion, a compound annual growth of 18%. He added that  90% of current futures contracts didn’t exist at the time.

“There were no stock options; there was no energy trading; no financial futures; no interest rates and no stock indices. All of this growth is attributed to new products,” Sandor said.

“What brought about the growth of these markets and how do you spot a new one,” he challenged the interns.

He then detailed how new markets are born. “The first thing that happens is structural change that creates the need for capital, then you have standardization, that is followed by legal rights followed by trading rights,” Sandor said.

Sandor then listed four innovations that brought about invention of markets. The first was the Limited Liability Company. “[This] came about with the Dutch East Indian Company in 1605, to finance trading with the Far East. The Chicago Board of Trade was born because there was a need to export wheat [internationally] in 1853. You had to have a homogeneous set of standards so that you could export the products both to the Midwest and the Far East,” Sandor said.

He then pointed out how the imminent demise of the Bretton Woods agreement, which basically fixed currencies and interest rates from 1945 to 1970, would provide an opportunity to create markets  for interest rate and stock index futures and of course currencies.

Finally, how the problem of acid rain on the East Coast led for the need to create emissions trading.

Obviously he was involved intimately in the last two.

“When you see a structural thing like that what do you do to capitalize on it? he asked. Sandor said you need four elements: “1) Is legislative, you have to have legislation that clearly defines the commodity that you will trade; 2)regulation; 3) you have to build the institution and collateralize it and  4) you have to design the contract.

He pointed out that as CBOT chief economist he worked with counsel, notably Philip McBride Johnson (note to John Lothian, try and book Phil Johnson for next event, his contributions to the industry have been enormous) to define a commodity in such a way to never use the term securities. “We called it good and services for futures delivery, we also provide that the new agency would have exclusive jurisdiction which mean no other agency like the SEC could interfere and thus financial futures were born.”

Several books can be written about the machinations regarding legal terms that created the first interest rate contract and the need to create the Commodity Futures Trading Commission (CFTC) as a separate regulator with exclusive jurisdiction, noted above. It allowed for the rapid growth of futures.

He also pointed out how with emissions, which are still evolving, he had to start from scratch.


Good Derivative Are Well Good

Sandor highlighting his recent book said, “I call them good derivatives. They are good because they are regulated, exchange traded, transparent, perform a risk transfer function and facilitate price discovery in both the futures and the spot market.”

The book was necessary because derivative has become a dirty word thanks to the Lehman Brothers fiasco and resultant credit crisis. The irony is that many over-the-counter derivatives where created as an attempt by those who lost market share due to Sandor’s innovations to gain it back.

He said the industry hasn’t done a great in simply explaining the benefits of “Good Derivatives.”

Sandor said, “We make a mistake in the futures industry because we talk about transparency in a vacuum. As soon as we started trading futures we started trading in 32nds that crushed the cash market spreads. That doesn’t make sense to the layman. What does that mean? In 2010 (last year of data) the U.S government saved $250 million in interest cost as a result of the minimization of transaction costs. Pension funds saved $5.6 billion.”

Hence good derivatives. They are good because they meet a risk management need that wasn’t available or was more costly.

Using market principles to reduce pollution makes more sense than simply having proscriptive rules that come at a cost with no chance to profit.

Sandor in his career has not only exploited opportunities others could not see, he actively looked for ways to benefit society through the creation of products that eliminate or reduce risk.

Sandor concluded by stating that the type of growth the industry has experienced over the last 40 years can be matched but only with the invention of new products. “The future is new products, the same way we grew the business before…  I believe the 21st century commodity is going to be water.”

Sandor is no doubt already working on it. And he added that there would be opportunities in intellectual property, biodiversity and computer capacity.

Hopefully the interns learned the difference between good derivatives and bad derivatives. Good derivatives are transparent and create an efficiency that benefits people outside of the industry.  Bad derivatives are opaque and were born of the need for institutions to offer more product and creates risk rather that reduces it.

There is fantastic opportunity here,” Sandor finished.



About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.