today it's called the international swaps and derivatives association inc and carolyn welcome very very much to conversations and to manhattan neighborhood network thank you very much and very happy to be here i wonder if you could share with us maybe we c begin at the very beginning in the most basic elementary level as it were for the general audience and you know some of the people in the financial world who might be viewing and so forth but what do we mean when we talk about we want to talk about the association of it down the line but what do we mean when we talk about a swap or what do we mean when we talk about a related derivative will begin at the very basic beginning principles and maybe you could share that with us and then we'll talk some of this illustration down the line but what is a swap and what does it relate to the riveted and where do they fit into the financial picture of the united states in the world economy ok well that goes for a lot of issues to take at once and i'd like to break it down and i'd like to start a very simple a but what as a swap and i think before we move into financial terms i think that i just look at where the term swap comes from and i think that will help people understand when we move into financial terms swap is often used em on the term among children if you meet a group of kids at may have french francs and somebody may have u s dollars somebody may have fixed cash flows somebody may have floating cash flows but it's an exchange and in finance general term it is an exchange of cash flows and why somebody would be interested in engaging in these exchange of cash flows is it allows them to alter their risk  profile so i think one of the questions too is where does it come from who uses it really business corporations and financial institutions it's a wholesale market product you know not a retail product i understand right and these financial institutions and these corporations are all facing certain financial business for us right now and this could be their exposure to interest rate movements their exposure to foreign exchange movements and their exposure to commodity price movements things that if they're really in the business of making widgets or some sort of product they want to focus on that they don't want to be sitting around worrying what's going to happen to the deutsche mark today what's going to happen to the price of natural gas today these are products allow them to and manage those risks of propre a lad appropriately and to hedge against them so he's sort of it's a risk management technique is more that really is what it's involved and i wonder if you could be in a world i'll get to why they've come into the picture so prominently as they have and we'll talk about that a little bit down the line but i wanted to use a swap winder stand the idea of swap your swapping risk either with floating currency rates or with fixed rates of interest and so forth or very fast well no i don't really i just try to do a new year like probably a great deal of this audience might be as well but is trying to get these kind of thing no is there a difference between the swap use of the swap questions that term derivatives has brought with it a lot of complications it's a very even as you've already alluded to the confusing word swap is not a confusing word no and the interesting thing i my association called itself the international swap dealers association until one thousand nine hundred and three and if you take a break down and look at the products the actual derivatives market that my trading trade association represents will find that eighty percent of the products that are actually engaged in by these corporations and financial institutions are swaps and exclusively interest rate swaps not even getting into another format currency swaps so when we do talk about swap and other derivatives it's important to note that the derivatives market which embraces swaps as well eighty percent of that derivatives market is interest rates wops i see ok and another five percent or so are currency swap floors you know i don't i was just trying to get across the point that the swap is the majority of the market and whether you want to define derivative it becomes a little bit complex because you use the same word to define it but derivative as something that takes its derives or takes exact alue from a movement in an underlying index or interest rate or commodity price so in other words we need to move back to what is a called like for futures and options and so would i sometimes refer to as the routers is there sometimes confusion in the public or even the financial world mind between what other instruments that are called rooms and what are really and truly factors you understand is related to routers as you mentioning that the trade association again by all means we want to let people know about it and that's where the distinction is made there derivatives there's a broad group of derivatives and the way my association does not claim to represent i see we represent what we call privately negotiated bilateral contracts between two counter parties now there is a whole nother group of derivatives which a lot of people are probably more familiar with and those are the exchange traded derivatives main they have been around forever and if you act in the united states they were introduced in the civil war in the eight hundred and sixty s along but this is a way of bridging life on commodities side the farmers they wanted to find a way to be able to hedge themselves because their return was going to be dependent on a lot of factors outside of their control such as the weather is on land condition right and unfortunately it to allow them to run their business which was their contract sizes and contract dates right like for example in my world which is much more on the financial side the contracts trade have settlement dates every three months and in september june march cycle so they're their last flexible if you will whereas the private contract between the two of us we can agree to settle on any date yes instead of having a fixed contract size you and i can agree with somebody whose business cycle things may start out slow their exposure then it may increase then i know it may go way back down and it's very easy to do that if we're two of us are working out a contract to get better whereas on the exchange traded which is again they're very valuable hedging products yes there's a distinction there in fact most a lot of financial institutions like to hedge in the exchange traded market but it's something to additionally that corporates like to stay away from because they want to try to reduce their risk to the bare minimum so they had preferred to have this tailor this timely in a way that you say the the old arose went back to the civil war these are relatively recent and what was there did it have anything to do with the going off the gold standard did it have anything to do with the world bank international monetary fun used previously he makes some very good questions there is certainly what was revolutionary about that time period as the financial condition was changing a lot and that was through just as you already referred to the gold standard and going off know exactly and so there was a lot more risk if you will on foreign exchange side also in addition to that in the united states  you need to keep in mind that it was a period of very high inflation and very high interest rates yeah a lot of which some people today don't really appreciate that rates can get up to twenty one percent amazing and certainly convinced a lot of people back then that there was a and they came up with a new with these ideas out of whole cloth in a certain sense and you also had to keep in mind that businesses for expanding a lot more internationally at that time it was much more of a need to look on the foreign exchange side to head and also communications had changed quite dramatically with online right and that allowed people to be in touch because if you can imagine if i have a swiss franc exposure my natural offset might be a swiss company who has a u s dollar exposure and really facilitates if i'm able to speak and communicate on a regular basis with that natural swap counterparty yeah well so it's the communication that was bringing the market and making it smaller in a way by having this constant international communication and that's on the that's on the currency exchange rates and then the fact that we have these incredibly high interest rates  people to begin to think about some creative ways of  came for a suit did ok and it was a product that in my opinion really revolutionized corporate finance and as we knew it because traditionally a u s company that wanted to be conservative and prudent if they wanted to raise money if they didn't want to take foreign exchange risk they needed to borrow in u s dollars ok so in other words u s companies were limited to the u s capital market all right but you can imagine that there might be some swiss investors that would like to invest in the u s companies but they as individuals certainly wouldn't want to invest in u s debt or u s securities and take the exchange rate right themselves and likewise swiss companies were following the same sort of prudent guidelines if they needed to raise money they went to this was capital markets and what was very revolutionary about the product is that there were always pockets of demand would agree to pay the swiss cash flows associated with this u s companies debt and in turn they would pay dollars and then likewise you would see the swiss company borrow in u s dollars and they would be receiving  markets the most efficient that they could be and allow institutions to achieve the best in lowest funding cost that they possibly could i as the swiss company now borrowing in u s dollars was it back into swiss at a much lower rate than if i'd gone to the swiss franc market directly and that's because i'm satisfying the demand for u s investors to hold exposure to swiss company so it's a way talking about the communication that was already making the world smaller this product made the world smaller because it said there isn't these isolated pockets of capital markets right is really one world all my born where i am are in this made it possible to to not have to assume the kind of risk financing costs overall wanted to bring the world financing costs down and how exactly does that bring that down how does it improve or bring down the cost of financial you know the financial cost because  corporate borrowers are being able to have access to new markets right where there's an appetite for their debt and so that they're able to borrow at a much lower lock it and you can't you can't you can't you know if you're making a big condor if you can't really you don't want to have that kind of uncertainty in terms of you're setting up a business arrangement you're going to make an investment somewhere you want to have a certainty that is sort of like an insurer is london surance proposition is it is want to know you know what it is nice to have it there it is that way exactly whereas with a small object you've actually locked in something you know able to get certain take and something you do want to use right i do want to know that i'm getting very exciting time where the market and you've already alluded to some of the large volume that currently because a product to so valuable it's really taken off but in the early days i mean i remember my boss st telling me w transaction define the basic terms set the bait basic standards some basic definitions roy and since it was fairly revolutionary not all banks were entering into the trades with each other they were entering into trades with their corporate clients right over roy and as the product grew people realized that they were spending a lot of time renegotiating things that basically could have been standardized and that would have facilit in under certain circumstances and under these contracts and trying to put together a bunch of terms and so the idea was well why should we continue for each new deal because now banks have begun to every single time the same issues would come up how do you want to define this term how do you want to define that term so a group got together and said let's just carve out a group of standard terms and from there that this really ought to help make the product grow because people could then working as an industry collective lead to go out what the standard document rather than each farm individual labeling their own with their own law to the degree that you can get a generic statement that you can use you can just save all the time renegotiating it just fill in the blanks with the with the agreements that can be done and so you can spend your time and energy negotiating the reality rather than rewriting reinventing the wheel each time you want to do it on price and the association was instrumental in the stablish in that master agreement that saqlain the members and then back off a little bit and talk about major players involved and in the market but it's largely the financial institutions meaning commercial banks and banks securities dealers insurance companies also some major corporations also some law firms accounting firms but primarily financial institutions and corporations give a three way you have a three way pattern of membership i think as primary members and then associate members and affiliated members or something maybe you could talk about that three way break down and who they are and what they represent and so well you could certainly and the primary members are the financial institutions and what we had considered dealers in the market swaps do is write me and keep in mind that they originally right those are our primary members and they're the ones who would be able to say to be on the board etc and they would represent in a certain if i may they would represent and i saw another figure in the literature that you provided forty percent perhaps are in north america t can be proud of as the growing international arena in which the market is shaping up because if you took a list at the very beginning i would dare say it would be a little bit more concentrated in the united  begins to grow in a grows and then it is the number of people who became involved in doing deals as it were or doing these arrangements grew out presume because it grew as a new a new vehicle a new business practice the number of people who  grow to this who would join the association would grow i suppose in that it went from being a small startup thing to where as you say you were doing few deals at the beginning but then it grew very rapidly and then the stature of the people became involved in this business  itself of solidifying and building the association and just maybe backing up beyond that the idea itself where do we're going to actually come from was the genius of one person or did it come out of a group of people meeting at some time i'm sorry the product or world i was thinking of mostly both the product the idea that so initially was that the was that to come for blown out of the mind of one particular individual or out of a group of people and did it come from somebody who was part of a major institution or did come from somebody sort of more interest than normal that got this idea and just sort of established in the financial reality that is the world now i think i think is you already alluded to that this derivatives in an weather which would make the crop very bad and he went to the industrious all of farmers and said how about i give you money now and i have the right to buy your all of us let's say a twenty dollars oil and then going price for all it's worth ten  and they said well this is great they thought it was free money because they cannot envision a world where all of those might be at twenty dollars and sure enough the weather was bad the crop was bad he later went back to the farmers the price is now thirty he says g was sold so well you know i didn't realise but and i think i was thinking when i asked this question about where did it come from in the modern incarnation as it were you know after this nine hundred and eighty period and when it began to grow and whether that that was a matter and you say you were there at the you were one of the phone doing the phone and father's founding fathers or mothers of this concept you know so i was just sort of the excitement of a beginning of a new idea is usually very exciting and so you know it was and it was very exciting i mean again i just it's the chase manhattan bank and he would have been one of the initiators of one of those but as you mentioned the concepts were new and i would say just about every major institution itself with sort of coming up with the idea at the same time  came with their own customers there was a unique situation in britain at the time where there were foreign exchange controls right on sterling and there was a product called the back to back one parallel long identical to a cur o the only exception being that it was two separate loan agreements rather than a swap agreement but again so the concept wasn't new there were various products related to what dating back again whether to agree or rather to just something due to the fact that there were exchange controls that were prohibiting free trade between britain and other countries but it is what you mentioned before everybody had the kind of the same idea at the major institutions because they had customers that were facing the same problem or rising interest rates in the united states as you know but those things had risen over the years or been ups and downs and interest rates ups and downs and currency exchange every one of the years but it was just again that there was this that we haven't really discussed this but usually the role that financial institutions or my primary members the dealers point to this is they stand in the middle on transactions so in a general motors on the other side ok general motors and mcdonald's would not be doing a swap with each other and their original days at the market they would have but general motors and mcdonald's would say our business is not credit risk our business is not to understand or whether or not we want to be in a five year contract right with this other company that's when they ask the banks and the investment banks to step in the middle yes so so for example going back to my st institution chase would do a swap with mcdonald's and then chase would do the opposite transaction with general motors right so that it would have would link those that the work of a particular group of a small group of people and maybe you could share with those who was involved you cite a bit of that and then as the and then if you could share with us a little bit the growth of the business as it were because as you said you're the person you were working with said you do maybe four deals in a month or something and then you also and pick up ten dollars twenty cents and it's growing very rapidly because you give us quantitatively some of the the the amount of financial arrangement that is involved in these on a world scale and what the dimension understand writing that if i wanted to enter into a currency swap with you we need to peg the currency flows to some sort of reference point this is the notional principal amount so if i wanted to hedge most two percent yeah but even at that i mean in a growth of forty seven percent this is some incredible phenomena of the schooling on in the world society i mean that is just staggering the amount of i mean it would be i saw in some of the literature that maybe you could share with us than that that this is a principle that it seems that a great number of business operating people people operating a business and so we feel that this is something that is either crucial or absolutely essential to doing business are the benefits the drews swaps and routers derive even i saw one person refer to the fact that if companies do not use the benefits of these risk management corporate treasurer or financial treasurer kit for managing risk and i think you're point well taken that at some point we will see a world where if there  was gross negligence in terms of not hedging a risk where there was a product of available to hedge that risk and i think you will see people held accountable and there is eleven law case where that happened and that was it's not creating any new risk oh i see ok but it's a new way of addressing right and if i had an old way of doing it i had a new way of doing it why would somebody use the new way as it's the lowest cost alternative let's put it on and hopefully what will be a simple and clear example st i want to caution that when i use this example it's not to imply that individuals can do this so i understand this is financial institutions let's just take an example that most people probably can understand and certainly since i got a mortgage a while back ago i understand the process let's take a look at somebody an individual who is looking at getting a mortgage right o k and at the time floating interest rates around five percent all right they say great i want the variable rate mortgage sign me up for that and at the same time they have the alternative alternative because the current prime rate is at five he thinks this is great whereas if you had locked into a fixed rate mortgage that would have been eight and one of the reasons for his decision as he thought that the growth rate of the economy was going to be slow down inflation was going to he is with this variable rate mortgage and he's pretty unhappy about it and wishes that he had taken the eight percent fixed rate right this is exact same thing that a company might be facing right so what can you do this is what i mean by the have probably different terms different covenants different restrictions or refinancing alternatives it's going to be a fairly lengthy and time consuming process and it's also head to head negotiating and everything works imagine a world where he calls this  bank and says gee i really want to do a swap could you swap me out of my floating rate mortgage obligation and can i lock in now since we know rates have already moved up a little bit at eight and a half and basically is the financial institution the swap dealer can say done within a matter of mere moments so rather than having to go back and renegotiate a mortgage cancel a mortgage where the market can be moving on them you know minute by minute ri enough to know that question comes up all the time this swap deal or does ultimately one to match his portfolio so he wants as many people thinking that rates are going to go up as many people are thinking that rates are going to go down and you'd a what i might perceive as an inflationary environment you may not so there are differences in perception also there are different restrictions some corporations are required if by their by the institutions that are lending to them that they have too much exposure to rise in interest rates that they need to find a hedge i can guarantee you that cooperation chooses to do an interest rate swap it's because it was the lowest cost alternative to th interest rate so there are different forces that play you know why one person might want to in this case have a fixed rate mortgage and another person might want to have a floating rate mortga and that's what the swap dealers comparative value is that's what they're supposed to be doing in the economy is being able to match these counter parties together in some sense as i said is more complicated than yours and i know no swap dealer today because that's the world has moved much further than that but in the original days any swap deal or you could look in the portfolio and i can tell you this can a party is matched against that one that one that one now you know a four year deal might be hedged against a four and a half year deal or no deal for twenty five million might be had for a deal twenty million but they're away and techniques that the dealers have of insulating that risk and other people particularly trained in this is the new is this a new discipline in the world of financial  while education and so forth those are the special training this new for this do they take special training in the business schools now i know you look through the business school somewhat trying to bring them up but is there is there an educational role for the people in the  financial institutions and in the financial world to be educated to the to the to the techniques and the realities of this or do is just your normal banking education equip someone to deal with this or to need special training or understanding well the school system has kept up very well i would say in terms of where the business has moved to because now if you go look at a general textbook of corporate finance you will see references to interest rate incurring swaps and the option thing understanding what a bond is understanding corporate finance and structure now just as that was basic to corporate finance education the role of the interest in the currency swap you know there's just a dividend them to it in a certain sense and but do you have a role in trying to educate people to the the skills that are needed while it's changed quite a lot in the beginning you were trying to educate people internally  institution you spend a lot of time trying to educate the people who are making the loans to market to their products make market the product to their customers and because there was no and house training program right at the bank had said the robotic specialist had to do association over responsibility for you said this mathematical master agreement that was one that was done that was able to make it possible for there to be a more a more you know free flowing exchange of capital and so people would focus on the transaction exact corporation is fundamentally facing some sort of interest rate or currency exposure not all of them one necessarily have the same exposure to commodities and certainly if you polled right a number of surveys have highest risk that most corporations say is the interest rate risk right and then nd is they currency and rd is the commodity i see right ok so that you know i wonder is it is it possible to see this is part i would measure before insurance they extend outward into the future which is an important part of business planning and so forth is there is there any possibility this be seen as a general movement toward insurance or risk management as it were against or systems of assuring against business laws that would make it easier for businesses to be i will operate more effectively and with greater shirty is the thought and projected into the future i don't know if you can get what i'm getting at or not is there a movement to try and under try and take advantage of the ability to create a business climate that is more sure for the management of corporations as they begin to project ahead by by setting up new instruments perhaps or new new new arrangements that can make it possible for them to know with greater certainty what conditions they're going to be operating within five hundred and ten years or so months and there's a general tendency in world finance to move in that terms of allowing people to operate with greater certainty one of the things when i was on the corporate dealing side that a lot of customers came to ask for is they would be bidding on a project and they would be competing in terms of bidding on a project ok and quite often if you're going to be putting together a project you need to obtain financing but you're not you know and then get that financing until you know that you have the commitment that you are the winner on this so let's take let's take a hydro power plant to me that's the type of competitive bidding situation that i used to work on quite a bed there'd be a number of institutions that would be betting on this and they needed to know what their cost of financing would be but they're not going to go if i'm competing with three other companies from to get that right to do this project i'm not going to go unlock and some debt because i may not get the project so how on earth am i going to you know pay the great things about the derivatives arena is what somebody can do is come and say gee i don't know if i'm going to get this project but i would like to buy an option that my interest rate costs will be no more than eight say if interest rates fell down dramatically they would be taking a huge loss yes because they would have that money to invest let's say rates fell to three dollars they could invest the money that they borrowed at three dollars but they would have this eight percent obligation to pay and so here they are stuck with the whole debt exposure where as at least with the option product it gives them assurance it gives them a way to plan ahead a plan for their bed not be stop with the borrowing if they weren't able to go through to the project so that is just a introducing any new ways there are all the same and there were products for people to manage risk so before whether you want to be in fixed interest rates or floating interest rates corporations were able to do that before ye so it's not necessarily changing corporations i mean let's use here is making it much easier you know giving a lot more flexibility you know if they feel that that made the wrong decision and would like to change the structure they can get out very easily and a minimum cost rather than going before we said before and that mortgage example having to renegotiate yes and cancel something might never get done company wouldn't get done it's just going to be like our sclerosis of the financial system or something like that it would get to you know it's  the regulatory role of government the role of the financial of the regulatory agencies as you see and so forth what role do they have been playing in this should there be or is there a regulatory agency that pacific blue specifically last couple of minutes you know the end of the program ok just so you know derivatives are definitely regulated but they are not regulated as a functional they are regulated institutionally all right meaning that for our members who are banks they are there during this activity are regulated by the federal reserve system and office also the office of the comptroller the current say and having better and commercial banks for the past ten years i can tell you that there their viewpoint or their their regulation is quite there l o and they do understand the business they come in they ask the right questions and so there is definitely supervision development one of the great the said people found this working together it was a great educational for an not only you know for other financial institutions or corporations but also for that regulatory  general all the regulatory community has been very favorable on how the derivatives business is being monitored ok i do not see any need for any greater supervision than the current system already has in there those are built in there but this is one of the things that the association one of the benefits of this illustration is that you can help inform people in the regulatory industry of the realities as they are emerging and also this role of helping to educate the people within the financial arena as it were to to the new realities new contractual agreements that have been worked out for you know master agreements plus as it were by the association it keeping the internal nature of the industry well understood and one last function perhaps that maybe we've tried to sort of a little bit here today is to educate in some small way the general society to a phenomenon in the financial arrangements of our society even though it is not you know retail as we say is wholesal financial situation has a tremendous effect upon the the overall functioning of our economy lowers d the costs of doing business which can be passed on to the consumer so one of these a lot has a major effect and we have tried to help share some of the remind you in the audience when you play you have perceptions and again caroline jackson she's executive relatively newly appointed executive director of the exciting institution the international swaps and derivatives association incorporated located here in new know oh yes we've read the literature and it's very interesting and there should i think it's i think it's something that the general society would be very interested in you know i mean the general you know the viewing public i don't know if you can follow it all or something but there would be more of a role for having the general public  understand and those figures that you give are absolutely staggering those imitation of figures are just like the gross national product of the world or something you know if it seems like everything is wrapped up in it but you want to take one or two percent of that in right but and then a forty seven percent growth rate that's amazing so this year what would what would be the level of the deals that are going to be done to see if you project from one thousand nine hundred and five you know what would that figure be the trillion dollar outstanding a lot of contracts mature what i think would have been an interesting number as if we could have tracked the total notional principle of all contracts written since its inception and while that would be much that i'd be done there as i've been doing because it's a hard thing