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Split Derivatives – Sandor’s argument for financial innovation for the environment tells us little other than his life story

The problems of Good Derivatives begin with the title: the book does not discuss derivatives at length, nor is there a coherent thesis proposing that they
are “good.” Equally misleading is the subtitle; financial innovation is merely referenced within the larger story, and environmental innovation is not even
mentioned until late in the book. Only at the byline do we truly understand the crux of this tome. What lies within is a retelling of the life and times of
Richard L. Sandor, replete with name-dropping asides, chronologies of meetings and phone calls, and Zagat-ready reviews of people and places folks can post
on the back cover of their next work. The Petraeus scandal reminded us that all biographers infatuated with their subject matter, and it is just as true
for this autobiographical memoir posing as a technical defense.

This book intended to, per Sandor’s introduction, defend against the blanket criticisms of complex financial products and explain what finance has done
(and still can) do to better our world and the environment. Indeed, I want a champion to can make that argument. I want someone to describe how a robust
futures market kept US farmers afloat during the 2012 drought. I want someone sagely explaining that environmental costs and benefits need to move beyond
the realms of mitigation banks, disaster insurance, and externalities we currently see.

Sandor has the experience to do make that argument. Likewise, his works are storied enough to deserve a lengthy memoir. His ventures read as though he were
the grandfather of modern finance, and in the words of Shark Tank’s Kevin O’Leary, I don’t know if that means I should arrest him or give him a
medal. Sandor played a leadership role in developing most financial innovations you can recall from the last 30 years, transforming it from the boring
trade of bean-counters to the dynamic behemoth it is today. The development of non-commodity futures instruments, electronic trading platforms, for-profit
exchanges, exchange mergers, and non-traditional securities and instruments, all can be traced back to the efforts of Sandor. If these also sound like the
stepping stones that led to the Great Recession (see Chasing Goldman Sachs),
congratulations, you’ve been paying attention. However, these innovations increased efficiency and provide great utility (e.g. no need for swaths of people
making hand gestures in a trading pit, institutions are more easily able to hedge investments, see: any edition of The Economist). To make matters more
complex, Sandor has also done the most to advance environmental finance and corporate environmental stewardship for decades. So how should history judge
the man who paved the way for both the carbon credit and the credit default swap?

Sadly, Sandor spends more time recalling anecdotes than answering that question. Discussions of environmental finance do not appear until page 300, and
descriptions futures markets and their utility are scarce. When critics appear, Sandor “chuckles” at their critiques instead of providing a counterpoint.
Few, if any, individuals will read the book and have their minds changed about finance at large and its uses for the environment. Even more frustratingly,
the arguments for environmental and financial innovation that are offered are unconvincing and fail to move the debate forward. Below are the two most
often-mentioned arguments that I found wanting.

First, Sandor takes it as self-evident that flourishing futures exchanges and the additional liquidity for traders are an overwhelming net public good.
This is especially frustrating when critics have observed modern high-frequency trading ventures serve to primarily exploit and remove this additional
liquidity. “Exchanges didn’t need bailouts,” he writes towards the end, which is a straw-man argument. Similarly, the NYSE effectively executed stock
trades during the 2007-08 crash, but the concern was the instruments being traded were suddenly tens of percentage points lower. Certainly, housing bubbles
and buying on leverage were around before derivatives. But the pervasiveness of these instruments drove firms of every stripe to begin to play in them,
convinced that they had a hearty revenue stream while successfully mitigating risk. Just the opposite was true. And while experts agree the heart of the
derivative problem stems from unregulated and non-transparent over-the-counter (OTC) markets, Sandor finds them to be an inevitable consequence of a
derivative or instrument that enjoys a large primary market audience. Sandor trumpets his role in developing the Commodity Futures Modernization Act of 2000, (again, if that bill
sounds familiar, congratulations: you’ve been paying attention), then demands that derivatives not all be considered as OTC-traded credit default swaps in
an off-balance sheet special purpose vehicle. The problem is the system, which he helped craft, made no such distinction. So when Sandor remarks that the
development of investment rate futures would save every homeowner an average of $5,000, it warrants mention that Great Recession cost the average American
Family more than $57,000 in their home’s value (source, CAP, using 112M American families).
Derivatives may not have destroyed markets, but in Sandor’s hands, the case seldom sounds like something other than a twist on “guns don’t kill people.”

Second, Sandor does not provide evidence that market-centered solutions achieve greater environmental or economic gains than direct regulation. The
efficacy of Sandor’s sulfur dioxide (SO2) “cap & trade” system following the Clean Air Act amendments of 1990 is undeniable (and he deserves praise
bringing regulation-averse industries on board with the program). But what is missed is any discussion as to whether a “command & control” approach –
that is, the EPA requiring all smokestacks to install scrubbers – may have worked any better. One may presume the trading approach allowed for greater
industry participation, less impact to GDP, and negligible change to health benefits, but these are never quantified. Similarly, the striking differences
between SO2 pollution (small number of large emitters, constrained area, and a single evident technological solution) and climate change (unquantifiable
number of sources and sinks, global area, and myriad solutions of uncertain efficacy), and the applicability of the financial market to each, are never
addressed. These are the real conundrums that need to be considered when developing regulatory schemes, and ones I had hoped the book would highlight.

So what can be gained from the work? As a memoir, it serves effectively. As a case study for innovators, it provides some useful reminders: build a
network, find great advocates, and prepare for a long, hard, and often lonely slog against conventional wisdom. As a call to environmental action, it
concludes – maybe not forcefully enough – that key to an effective market for environmental goods is first a strong and firm commitment by governing
agencies to regulate. However, these lessons can be found elsewhere in more engaging material.

I wanted to believe this book was written with noble intentions but misguided its execution. But an audacious claim on page 305 forced me to think
otherwise. As he touts the successful passage of the CFMA 2000, effectively handicapping government regulation of OTC derivatives, he wrings his hands that
the bill was not a total win for his team as stock futures were regulated by the SEC and CFTC. Breathtakingly, he cites Luke 16:13 and complains that one
should not serve two masters. That bible full quote actually reads, “No servant can serve two masters … you cannot serve God and money.”

Mr. Sandor, the flaw of bureaucratic layering is not the same as contradictory life purposes. The dictum you’ve chosen also seems to brilliantly summarize
your book. You allege that the financial innovations you’ve developed are working to serve the former master. Yet what is written only provides fodder for
the argument that they’ve served the latter.

Two of Five Stars

How to Order:

Good Derivatives

Author: Richard L. Sandor

Publisher: John Wiley & Sons, Inc.

Pages: 615 pages

ISBN: 978-0470949733

Related articles

Good Derivatives: A Story of Financial and Environmental Innovation – Book Review

(11/18/2012) In Good Derivatives: A Story of Financial and Environmental Innovation, Richard Sandor, PhD has written a rich compelling first-person narrative of the development of financial futures and environmental markets over the past 40 years. With personal stories describing both failures and successes, Dr. Richard Sandor engages us with details that expand our knowledge of the capacities and limitations capital markets present to us in our efforts to finance climate change mitigation and natural resources conservation.

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