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December 10, 2019  |  Podcast
Incentivize Good
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Known as the father of financial futures, Dr. Richard Sandor, chairman and CEO of the American Financial Exchange, joins us for an in-depth conversation about his journey to becoming a financial innovator. He discusses creating the Chicago Climate Exchange; his newest venture, Ameribor, an alternative to LIBOR; and why doing well and doing good don’t have to be exclusive.

Richard’s comments are edited excerpts from our podcast, which you can listen to in full below. (42:21)

 

You created Ameribor. Can you tell us why you created it and how it works?

Richard: I picked up the Financial Times in 2011 and saw an article about the Royal Bank of Scotland firing four people for manipulating LIBOR. Forty years in the finance business taught me that it takes two to collude, so if there were four, there were likely 40 or 400, making this a structural event in my mind. And when structural events like this occur, one has to make a judgment. What is the next 10 to 20 years going to look like? I always try to look 10 to 20 years from now and imagine the change that has occurred over the last two decades and extrapolate that into the future.

We called a team in and made four assumptions. First, LIBOR would lose its preeminence, leading to a cascade of difficulties in the market. Second, zero interest rates were not sustainable. Third, the world’s largest economy should have its own interest-rate benchmark (because 22% of the world’s GDP relied on international and multinational indexes). Fourth, the Fed had to relent on its policies on interest on excess reserves, a response to a catastrophic decline in GDP in 2007 and 2008.

So we said, “It will take a decade, but let’s create a new substitute for LIBOR and trademark it Ameribor. London has LIBOR, Europe has Euribor, Hong Kong even has HIBOR. America has nothing.”

How well accepted was the idea?

Richard: The idea was criticized. People said, “We don’t really need an overnight unsecured lending market. We borrow from the government, we lend to the government. Interest rates are zero, go back to Chicago.”

But you know you’re right if you’re a contrarian when most people don’t think that what you’re talking about is realistic or is the right time. And so, my standard retort was, if you want to be on time, you have to be early. You have to be anticipatory. You can’t get a solution when it’s apparent there’s a problem.

We’re proud to have as our tagline “commercial logic with social value.”

How long did it take to gain traction?

Richard: This is a massive project that takes a decade. Two years in, we got some wind in our sails when the Fed announced it was forming an alternative rates committee.

In 2015 we went to the CBOE and said, “You have a great set of products, but you don’t have an interest-rate complex. And if you’re going to compete with other big exchanges, you need to be diversified. We’ll develop the index, then you can put up futures, options, ETFs, and ETNs and service the community.”

We launched the exchange on December 11, 2015, with four banks, averaging $13 million a day. We’re up to 163 members—30 nonbanks and 133 banks, representing about 20% of America’s banks and more than $2 trillion in assets.

We’re proud to have as our tagline “commercial logic with social value.” We had a Native American bank join. We have every FDIC minority bank in America. And we’re making a special nod to diversify at the CEO level and to get female CEOs.

 Could you talk more about the social benefits of this project?

Richard: We think we’re going to increase profits to banks and reduce the costs of borrowing by cutting down the bid-ask spread. And that’s really the name of the game. How do you minimize transaction costs? How do you build the network of users and keep transactions low so that the buyer and seller is cheaper to operate?

Given that the product already existed in other parts of the world, is adoption and the growth faster? Is 10 years too bearish?

Richard: It’s hard to shrink the process, especially if you’re in the business that we’re in—finding transformational change. We want to make a big difference; we’re not playing a marginal game. And when you’re trying to effect worldwide behavior, I don’t think there’s a shortcut.

Inventive activity takes a generation any way you count it. Journalism schools were using typewriters in 1980, five years after the personal computer was adopted. Power steering and television were invented in the 1930s and didn’t become ubiquitous until the 1950s. We started in 2011, so we’re eight years in.

As a relentless financial innovator, what have you learned about innovation?

Richard: Where does a new idea emanate from? What sparks it? How do you innovate? Invention is coming up with the idea. Innovation is the commercialization of the idea.

That takes time. Years zero to two you’re kind of a like an infant; years two to five a toddler; five to 10 a young adult, and 10 to 20 is full adulthood. And generally you have to raise $40 to $50 million to implement the idea.

People often call and say, “I have a new idea. How about cannabis futures?” I say, “Great, then you have a half-percent done. Now get $40 million and figure another 10 years and you’re going to be on your way.”

 I think it’s a dangerous idea to ever short human creativity.

Where else in financial markets do you see problems that need solving?

Richard: We have water problems, blockchain, the role of a clearinghouse. Do you have a trusted network? Will exchanges exist, and what form will they take? Will they be ethereum-based? The only constraint is time. I see more change in the next 20 years than I saw in the last 20 years. And I think it’s a dangerous idea to ever short human creativity.

When you were launching the Chicago Climate Exchange in 2003, people referred to the problem as global warming. It’s now been reframed as a climate emergency. Do you think a broader policy response is increasingly inevitable?

Richard: It’s important to recognize that the United States is a federal republic, and the success of climate markets and cap-and-trades is directly proportional to the distance from Washington, D.C. The further you go, the more you find local solutions. The perception is we have no public policy on climate change. The reality is we have open interest in North American carbon, more than 700,000 contracts, which means that North American’s carbon open interest is 40% bigger than gold.

What do you think about the progress we’re seeing in China?

Richard: It’s game over as far as I’m concerned. I gave a talk at Peking University in 2007, “the Harvard of China,” starting with the basics, such as “What is an environmental market?” The dean looked at me like I was insane, raised his arms, and said, “Jack up the level. You’re talking down.” Every university student was bilingual, and there was an undergraduate emissions trading club.

Lest we think this communist country doesn’t get it, remember that they have to deal with a trade-off. They have 500 million poor people. They’re going to get around to reform, and when they change, it will be massive. You’ll get 1.4 billion people moving in the same direction. A lot will change when the world’s largest emitter institutes cap-and-trade.

Do you see the link between corporate performance and ESG strengthening as environmental and social issues become increasingly material?

Richard: I do. The folks who get to leadership positions—CEOs—are very savvy people. As shareholders speak out, managements will pay attention. And then you will hit a turning point. Capital markets change quickly because the assets go up and down and you don’t have a 40-year fixed piece of plant and equipment. And people are incredibly capable of pivoting when they have to.

Is there a risk that companies change their behavior to look good on the things that can be measured and quantified? In other words, do the metrics inform the behavior, rather than the behavior informing the metrics?

Richard: Much of the environmental movement began with “punish the bad.” But the job is not to punish the bad; it’s to incentivize good. This is really the issue, and I helped launch the Dow Jones Sustainability Index to play a role in investing something like that. There’s no more powerful signal than price. Whether it’s the price of a stock or the price of pollution, once you put the idea in place that it pays financially not to pollute, you’ll change behavior.

The goal is to provide a solution that drives rational, economic behavior. How do I make it rational for you as a profit-maximizer to provide commercial logic and social value? That’s the job of an inventor.

So you firmly believe that green is both a moral and an economic color?

Richard: I think you can do good and do well. They’re not exclusive. The idea is not to be negative; we all know what the problems are. The goal is to provide a solution that drives rational, economic behavior. How do I make it rational for you as a profit-maximizer to provide commercial logic and social value? That’s the job of an inventor.

In the current political environment, some are saying market-based solutions don’t always work and there needs to be an intervening hand. Are you prepared to stick up for markets?

Richard: I think we have a very unfortunate situation in the West, including the United States and Europe, in which political leadership hasn’t made the case for free markets. Because we don’t have many free markets in this country. There are many regulatory, institutional, and legislative efforts corrupting markets (“rent-seeking”). That weakens the fundamental ideal of symmetrical information, pure and perfect competition, because advantages are obtained politically.

I think it’s up to the academic institutions, to those of us who are practitioners, to identify market failures (like rent-seeking) and to try to curb them. I still couldn’t be more bullish on America, on Europe, on the Western ideals of democracy. By and large, the Western democracies have had 500 years of hegemony, and I think it’s because of free markets and social innovations and democracy.

I don’t for a second think that right time and right place isn’t a very important part of anybody’s success. A lot of people have ideas that don’t get a chance.

Do you consciously think about your process around invention?

Richard: It doesn’t much matter if it’s bond futures or acid rain permits or sustainable water markets. The idea is to spot a big trend; make sure you create a credible instrument and evidence of ownership; then create a central marketplace, build an exchange, and design the contracts. Then prepare for deconstruction of the contracts into OTC-like swaps.

Where did your innovative mindset come from?

Richard: I’m part of the silent generation. I grew up in Brooklyn and played competitive chess and looked at a world that was out of my scope. Then I went to college and watched Allen Ginsberg and beat poets in the 1950s. I ended up in Berkeley in 1966 and watched six years of social issues being born.

I arrived in Chicago in 1972 and ended up in the commodities business. After a set of circumstances, I was working in derivatives and acid rain, and somebody asked, “Could you commoditize acid rain? I’m just lucky. I don’t for a second think that right time and right place isn’t a very important part of anybody’s success. A lot of people have ideas that don’t get a chance.

For more conversations on The Active Share, subscribe to the series on Apple Podcasts, Spotify, Google Podcasts, Stitcher, or TuneIn

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Glossary

INDICES
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid ARM pass-throughs), asset-backed securities, and commercial mortgage backed securities.

The MSCI ACWI IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets.

The MSCI ACWI ex-US IMI Index is a free float-adjusted, market capitalization-weighted index that captures large, mid, and small cap representation across developed and emerging markets, excluding the U.S. The Value and Growth Indices are a subset of the Index that adopt a framework for style segmentation in which value and growth securities are characterized using different attributes. Multiple factors are used to identify value and growth characteristics.

The MSCI ACWI Small Cap Index is a free float-adjusted, market capitalization-weighted index that captures small cap representation across developed and emerging markets.

The MSCI Emerging Markets Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of emerging markets.

The MSCI World Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the equity market performance of developed markets.

The Russell 2000 Index is a market capitalization-weighted index designed to represent the small cap segment of the U.S. equity universe.

Index performance is for illustrative purposes only. The indices are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

TERMS
Alpha is a measure of an investment's return in excess of the market's return, after both have been adjusted for risk.

Beta is a measure of the volatility of an investment relative to the overall market, represented by a comparable benchmark.

Half-life is a statistical measure of the time required for the discrepancy between price and value to contract by half of its starting value. Fundamental value estimates are based on the Dynamic Allocation Strategies team's proprietary research.

P/E Ratio is a measure of valuation which compares share price to earnings per share, calculated using estimates for the next twelve months.

Standard deviation is a statistical measurement of variations from the average.

QUANTITATIVE MODELS – FACTOR DEFINITIONS
The William Blair Earnings Trend Model captures information about short- and medium-term changes in analyst estimates in an attempt to anticipate future estimate changes and stock performance. The score combines measurements of earnings revisions, momentum, and earnings surprise.

The William Blair Valuation Model combines varying metrics used to characterize the relationship between the stock’s trading price and its intrinsic value. By going beyond using only one or two measures, the model attempts to build a more holistic version of a stock’s worth vis-a-vis the market. The score combines measurements of earnings/cash flow based, asset-based, and model-based factors.