Billionaire investor Warren Buffett in 2002 called derivatives “financial weapons of mass destruction” while Arthur Leavitt, former chairman of US regulator SEC, said they were “something like electricity: dangerous if mishandled but bearing the potential to do good”. Complex derivatives didn’t do much good in the years 2007-2009. These financial contracts, known as derivatives because they derive their value from underlying assets, were major contributors to the crisis.
Eric Benhamou, a mathematician, watched the events following the collapse of Lehman Brothers with horror – but also with fascination. The mathematical models used by banks, insurers and funds to forecast the risks and values of complex derivatives had failed dramatically. Since most complex derivatives were not traded on exchanges, but “over-the-counter”, there were no public “prices”. “I felt strongly there needed to be more transparency around these products,” he says. “We needed to give investors an independent estimation of the valuation of their products, one that was scientific and rigorous.”
LEARNING FROM THE CRISIS
That vision was the genesis of EUROSTARS project Transparency in Financial Markets, which created a webpage that used a new generation of mathematical models to calculate prices. The project was led by Pricing Partners, co-founded by Benhamou two years earlier with Xavier Deschamps, who had served as senior sales manager at financial software specialist Sungard Reech. It gave Pricing Partners such a boost to business that news and data firm Thomson Reuters acquired the company last summer for an undisclosed amount. “It’s been an incredible journey for us as a small start-up company,” says Benhamou.
His team of 15 would have struggled to develop such a product alone, thinks Benhamou. Maths professors Bernard Lapeyre and Ekkehard Sachs at the Paris civil engineering school Ecole Nationale des Ponts et Chausses and Germany’s University of Trier spent months working out the new formulas, the “algorithms” to calculate derivative prices while Pricing Partners focused on the software that would use them. They used advanced numerical methods to improve accuracy and computing performances on advanced models extending the Nobel prize-winning Black–Scholes–Merton model.
The team came up with a webpage where clients can log in to look at derivatives in their portfolio and their estimated worth. They can select how often they want the calculations to be made and see the assumptions on which the calculations are made. “The client can see a lot of details about the assumptions and doesn’t need to be a mathematician to understand it all,” says Benhamou.
The academics involved in TFM have published a number of papers on their breakthroughs in financial formulas. Pricing Partners, part of Thomson Reuters since June 2013, began selling the platform in 2009 and now has over 60 clients, including banks and regulators who want to avoid a repeat of previous disasters with derivatives. “Eurostars gave us the chance to work with people from other countries and cultures,” says Benhamou. “It helped our teams in Germany and France to achieve real innovation.”