04/24/2012 05:06 pm ET Updated Jun 24, 2012

Richard Sandor: A Legend in Financial Innovation

Richard Sandor is not a household name but he should be. He is quite frankly one of the most important people in finance today given his 40 years of innovation. He is widely regarded as the "father of financial futures" for his pioneering work in interest rate futures.

Sandor has either invented or been on a team that has invented commodity futures contracts, option contracts, carbon credit contracts, and whole commodity exchanges. He's memorialized it in his new book, a memoir called Good Derivatives: A Story of Financial and Environmental Innovation.

As an Economist at the Chicago Board of Trade (CBOT), Sandor witnessed what was then record trading levels of 13.7 million contracts trade in 1970. By 2010, there were 22.3 billion contracts traded on more than 78 derivatives contracts in 36 countries. New derivatives and new exchanges were responsible fro almost all of the growth over the past 40 years.

American investors are as in the dark about derivatives as they've ever been. So how is it that a financial instrument can leave such a bad taste in people's mouths, yet they have not handled them personally?

"These are wholesale or professional products... the retail investor doesn't really deal with these," Sandor tells me during one of our many discussions. "It's very hard for them to understand because they didn't learn about them in school and most financial advisors don't understand them either," he says. "Investors know what they read in the papers for the most part."

Despite widespread belief that derivatives in general are WMDs -- Weapons of Mass Destruction -- those same instruments have saved Americans a great deal of money over the last 40 years. In fact, there is a direct benefit to all borrowers thanks to the existence of Ginnie Mae futures (GNMA is the Government National Mortgage Association and is often abbreviated Ginnie Mae or GNMA).

According to Sandor, thanks to the two main qualities of GNMA risk transference and price discovery... you can trace a savings of $718.75 for every $100,000 borrowed in a mortgage. According to Sandor's math, that's a savings of $109.08 per year per household -- a household that might not even know about GNMA futures or that they even exist. That is a good derivative, regardless of your political affiliation or economic strata.

"We based the original GNMA contract from the specs that were attributed to the CBOT Wheat contract and went from there." After 22 drafts and 2 years later, the GNMA futures contract was born.

To understand their benefit to society as Sandor delineated in Good Derivatives, you had to understand the duress that lenders were under and what the market environment was back in 1975. "There was no transparency in the loans and no competition." he said. "Who do you think loses in that scenario, the lender or you?" Mortgage salesman hit the streets with packaged loans that had enormous costs embedded to compensate the lender for interest rate risk as well as costs affiliated with selling the loans.

These costs oftentimes were as high as $4,500 per $100,000 loan. That's like a Mutual Fund "A" Share with a front load commission, but without the sales break point or as I said the transparency. A sales break point is a dollar figure at and after which point the sales load or costs associated with selling the mutual fund decrease... think of it as a volume discount on the investment.

Back to the Futures

In August of 2002, Time magazine named him one of the Heroes of the Planet for having designed the Chicago Climate Exchange, a derivatives market for reducing our carbon footprint. In 2007, Time magazine named him Heroes of the Environment for his work on carbon trading.

The commoditization of air, water, and catastrophic events that began in 2004 is no longer a chimera, but a solid reality. Sandor believes that water will become the crude oil of the 21st century. "Fresh water, which accounts for less than 1% of the global water resource, is a scarce resource" he said, stressing that the time to conserve is now. "You can't reverse desertification."
A new derivative might be the solution to annul water waste.

Good Derivatives by Richard Sandor is available in hardcover and Kindle versions. It's a memoir, with a trove of financial history over the last 40 years. Students of the global markets, financial engineers, and also elected officials and their advisors who would like to learn about financial solutions to their problems will enjoy this book.