Once upon a time I was a global fixed-income money manager, investing in government bond markets worldwide. Being a global bond money manager was my core professional competence. But to get to a country’s bond market that I thought made good investment sense, I had to incur foreign exchange risks. I never thought that currency risk was an asset class, but a means to an end, my end being the government bond markets. The last thing I ever wanted for my client was to see great bond investment performance wiped out by the associated currency risks. I used all the available derivative instruments to manage currency risks in many and various ways – forward foreign exchange agreements, futures and swaps to lay off risk, options to mitigate or play with risk – all at considerable expense. Sometimes they did hedge the global financial risks, but often they failed to perform in the way I had hoped.
I recognized that the management of global risks would become a growth area in the financial services industry and that the existing practice of using derivative instruments was in need of improvement. With the globalization of business around the world, more and more companies are doing business with each other, but as a result they are also incurring greater global financial risks. Corporates have currency transaction and translation risks, and if they are manufacturers they have hard commodity price risks. Insurance companies are in the business of selling insurance products, but at the same time they have assets, capital reserves and premiums received that must be invested in such a way as to ensure that they meet all of their liabilities to their policyholders. Non-life companies must invest their assets in a different way than life insurance companies because the liability of life insurance is a long-term risk, although non-life policies have long-term risks as well. Investing these assets, even with the most knowledgeable actuaries employed by the insurance companies, is not a core competency for many insurance companies. Traditionally, insurance companies have been allowed to buy and hold their investment portfolio without marking-to-market their investment values but accounting them at book or value. However, insurance company regulations have been changing throughout the world, forcing insurance companies to mark-to-market their investment portfolios. The new risk-based capital reserving is causing many insurance companies to rethink the way they manage their investment portfolios. Pension fund schemes are also finding themselves in a peculiar position, with huge deficits between the assets that pensioners and corporate sponsors set aside for their pensioners’ retirement. The way pension funds invest their assets and manage the relative risk between assets and liabilities must change. The investment management aspects of pension fund schemes will have to dramatically change to ensure that assets meet pensioner liabilities into the future. Most of these risks are not core to any business, whether manufacturing or financial services.
I have seen enough financial catastrophes; some were due to mismanaging the hedging of global financial risks or the misuse of derivative instruments, causing large-scale financial losses, intended or unintended. New models for managing capital market price volatility were being introduced, such as value-at-risk, which focused investors’ and risk managers’ minds on the actual capital market risks that any single institution is underwriting on any given day. But one of my main preoccupations was the damage that derivative instruments could do in the wrong hands: they are strictly for the use of professionals, the risk managers in the financial sector, and not for those whose risks they are designed to limit! Furthermore, global financial risks were being concentrated in the hands of fewer and fewer banking institutions.
While I was thinking about all of this I heard a speech by Alan Greenspan, Chairman of the Federal Reserve Board in the United States, on 14 April 2000. He talked about the need for the private sector to come up with new ways for bundling and unbundling global financial risks and the need to invent a new business process in which global financial risks can be transferred in a more cost-effective, hedge-efficient, transparent and counterpartydiversified manner. It was like a call to arms, and it sent me on a journey that still continues in early 2005, the product of which is the subject of this book. The Greenspan speech was my mandate to create something new and innovative that would allow non-professionals to bundle up their non-core global financial risks into a single hedging instrument, and to develop a new business process which would allow those bundled risks to be transferred to the professional risk-taking institutions in a more cost-efficient, hedge-effective and transparent manner.