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Tuesday, May 22nd, 2012
good derivatives

Richard Sandor showed up for his presentation during the “Research for the Practitioner” workshop at the CFA annual conference wearing a Don Draper hat.  And he kept it on throughout.  An iconoclast, obviously, and one that deals in issues that Draper never imagined, including financial engineering and global environmental issues.

Starting out, Sandor talked about what makes for a “good derivative.”  As befits his key role in the development of financial futures,Wikipedia | Here’s the crowd-sourced version of his bio. his answer was straightforward:  “Transparent, regulated, and centrally cleared.”  And bad ones are “opaque, unregulated, and have insufficient capital” backing them up.  It’s hard to argue with those characterizations, given that all the real calamities have come from the latter.  But that’s where the money is too, so the problem doesn’t seem to go away.

Sandor’s main topic concerned another kind of “good derivative,” however.  He was the founder of the Chicago Climate Exchange (CCX) and related entities, “the world’s first and North America’s only voluntary, legally binding greenhouse gas cap-and-trade system.”  The CCX closed in 2010, a fact much celebrated by those in opposition to the concept, as any online search for information about the exchange will demonstrate.

When Sandor sees problems, he wants to figure out how markets can solve them, and he recited a list of the benefits of markets during his talk.  But the problems are getting knottier and there is political opposition from both ends of the spectrum when it comes to addressing environmental problems with market-based solutions.  “The left wing hated us as capitalists and the right wing because we were nutty environmentalists,” said Sandor about his experience with CCX.the research puzzle | I can sympathize; when I worked in a big organization, all the Republicans thought I was a Democrat and all the Democrats thought I was a Republican.  As I wrote once, you can “color me purple.”

In a cost-benefit sense, the cap-and-trade system was a rousing success, according to Sandor:  $3 billion in costs and $120 billion in benefits a year, including 32,000 lives saved, which he thinks never could be seen because of the smoke from the political rhetoric.  “We aren’t thinking like we used to,” he said, citing the $2-3 trillion in costs in response to a $500,000 mission sponsored by al-Qaeda (another perspective that’s likely to make him unpopular with some).

He sees using markets in innovative ways to deal with potential environmental threats as placing cheap bets to protect future generations.  But that takes a consideration of probabilities and possible outcomes — something I wrote about on this site four years ago, regarding “warming up the models”the research puzzle | This was the eighth posting ever on the research puzzle. of analysis — not certainty about what will happen, which is the state of the discourse today.

Our approach tends to be reactive rather than proactive, throwing money at problems rather than thinking creatively in advance about what might happen.  That goes for investment professionals as well as government officials.  For example, Sandor asks, in the wake of events like Katrina and Fukushima, “Does anybody think that $500 billion of property and casualty capital is enough?”

While it wasn’t a focus of his presentation, Sandor thinks market-based remedies are needed to solve the water allocation and usage issues that are coming at us faster than we care to believe.  He sees “good derivatives” that can help us solve our problems — and named his book accordingly.Good Derivatives | Its subtitle is, “A Story of Financial and Environmental Innovation.”

As long as we are thinking about the future, I wonder whether these issues will be front and center at the CFA conference ten years from now or all but forgotten.  I’ll take a cheap bet on the expectation that this topic is here to stay.

This is the sixth in a seriesthe research puzzle | The PDF at this URL is updated as new postings appear. of postings on the CFA annual conference.