After having spent the better part of a decade as a derivatives trader for a major investment bank, I can now reflect on an important eye-opening journey into the way the contaminated world of derivatives really works. It is no secret that mouth-watering greed permeates Wall Street to an extent unprecedented in most other business pockets of the globe, but the derivatives subset of high finance is at the rightmost end of the spectrum.
Over the years, I have seen many traders, PhD quantitative modelers, marketers and "risk management" people work on deals. Essentially, the goal is to make as much money on the transactions (read off of customers) as possible. Although there is nothing wrong with trying to make money, it’s the way that the system works in order to achieve that goal that is the problem. Each meaningful deal is designed with more sophisticated and convoluted bells and whistles than its predecessor. There is a simple reason for this: the commoditization of financial products happens at a somewhat rapid pace on Wall Street so dealers continually move up the ladder of complexity in order to sustain their high mark-ups. What better way to achieve differentiation than by weaving an intricate and tangled web of confusion. In most other industries, such as personal computers or automobiles, that strategy would not work because the demand for such an esoteric product would be virtually nonexistent. But it does work in derivatives, as long as the seller convinces the buyer that this new product will better suit him in some way, perhaps by hedging his future liabilities better, etc.
This poor behavior has resulted in many banks having scores of long-dated contracts on their books, 15-year maturities not being uncommon, with no tradable or even observable market. But the trader has a market- his own. Thus, it is where he says it is. Clearly, even a rudimentary understanding of the power of incentives can help one understand how this system works. Obviously, a trader would rather make more money than less money so it follows that a structure for which there is no transparency makes it very compelling to mark as favorably as possible. So it is feasible to book many millions of dollars of profit on a trade for which there is no real market that matures or expires four presidential elections from now. All involved get paid in some way, directly or indirectly, on that business.
To be sure, there are quant jocks who use spreadsheets and fancy formulas to come up with models to price these structures. And it seems like a nice-looking spreadsheet, concocted by someone with a high IQ, with results that go out ten decimal places must be as precise as 2 pr. However, it should seem logical that anybody who can do that accurately not only would not have a need to be employed for very long but whose future could entail a Nobel Prize. Next, there are the risk-management people who are supposed to thoroughly understand the structure, as least as well as the trader, given that it is their job to understand risk. They are also supposed to act as policeman by preventing unacceptable risks from being put on the books. It has been my experience that only a small percentage of those individuals actually have a good understanding of the inherent risk in these deals because: 1) traders will not offer information to them that could potentially kill a deal and cost them bonus money; 2) it is very difficult to understand all the moving parts and how they could affect each other especially under turbulent market conditions; 3) they generally do not have the proper intuition as to how markets can trade as do their trader cohorts; 4) if they did, they could make a lot more money actually managing the risk on the trading side. There is, of course, the small minority that does have a good understanding of risk but recognizes that it would not be a smart career decision to step on the toes of a trader who is on the verge of reeling in a large "profit."
So who’s really to blame? It is the incentive system. In fact, most of the people, with whom I am aware and have had contact, are good people. But this is an example of how a bad incentive system can cause good people to act in awful ways. And when one deals gets booked with huge profit, the resulting pressure and greed leads to more deals. This crack-addiction-like behavior will not stop until incentives change. And the longer a system like this gets abused without correction, the worse off society will be when the day of reckoning arrives. So far we have managed to escape the wrath of a derivatives tsunami and not have a financial meltdown. We were fortunate to escape the Long Term Capital crisis but, at some point, however, we will not be as lucky as we have been in the past. After all, our government is financially strained and a path towards fiscal responsibility does not seem imminent.
It could very well be that the next big financial crisis will test the tensile strength of our financial system, which would almost certainly have ripple effects on global markets. Clearly, the underlying problem needs to be fixed now before it is too late.
A change needs to occur in how profit is accounted. Under the current system, the "marked-to-market" profit is taken on day one minus some relatively meaningless reserve number. I suggest that booked profit should progress with time. So most, if any, profit will be taken at maturity, less the preceding year, and so on. Thus, economic reality will be better reflected than the present fantasyland approach. Of course, this would ipso facto mean lower bonuses for traders and everyone else involved, at least in the front-end of the trades. But maybe then more thought would be given to exactly what types of risk should and should not being taken on behalf of shareholders.
Over the years, I have seen many traders, PhD quantitative modelers, marketers and "risk management" people work on deals. Essentially, the goal is to make as much money on the transactions (read off of customers) as possible. Although there is nothing wrong with trying to make money, it’s the way that the system works in order to achieve that goal that is the problem. Each meaningful deal is designed with more sophisticated and convoluted bells and whistles than its predecessor. There is a simple reason for this: the commoditization of financial products happens at a somewhat rapid pace on Wall Street so dealers continually move up the ladder of complexity in order to sustain their high mark-ups. What better way to achieve differentiation than by weaving an intricate and tangled web of confusion. In most other industries, such as personal computers or automobiles, that strategy would not work because the demand for such an esoteric product would be virtually nonexistent. But it does work in derivatives, as long as the seller convinces the buyer that this new product will better suit him in some way, perhaps by hedging his future liabilities better, etc.
This poor behavior has resulted in many banks having scores of long-dated contracts on their books, 15-year maturities not being uncommon, with no tradable or even observable market. But the trader has a market- his own. Thus, it is where he says it is. Clearly, even a rudimentary understanding of the power of incentives can help one understand how this system works. Obviously, a trader would rather make more money than less money so it follows that a structure for which there is no transparency makes it very compelling to mark as favorably as possible. So it is feasible to book many millions of dollars of profit on a trade for which there is no real market that matures or expires four presidential elections from now. All involved get paid in some way, directly or indirectly, on that business.
To be sure, there are quant jocks who use spreadsheets and fancy formulas to come up with models to price these structures. And it seems like a nice-looking spreadsheet, concocted by someone with a high IQ, with results that go out ten decimal places must be as precise as 2 pr. However, it should seem logical that anybody who can do that accurately not only would not have a need to be employed for very long but whose future could entail a Nobel Prize. Next, there are the risk-management people who are supposed to thoroughly understand the structure, as least as well as the trader, given that it is their job to understand risk. They are also supposed to act as policeman by preventing unacceptable risks from being put on the books. It has been my experience that only a small percentage of those individuals actually have a good understanding of the inherent risk in these deals because: 1) traders will not offer information to them that could potentially kill a deal and cost them bonus money; 2) it is very difficult to understand all the moving parts and how they could affect each other especially under turbulent market conditions; 3) they generally do not have the proper intuition as to how markets can trade as do their trader cohorts; 4) if they did, they could make a lot more money actually managing the risk on the trading side. There is, of course, the small minority that does have a good understanding of risk but recognizes that it would not be a smart career decision to step on the toes of a trader who is on the verge of reeling in a large "profit."
So who’s really to blame? It is the incentive system. In fact, most of the people, with whom I am aware and have had contact, are good people. But this is an example of how a bad incentive system can cause good people to act in awful ways. And when one deals gets booked with huge profit, the resulting pressure and greed leads to more deals. This crack-addiction-like behavior will not stop until incentives change. And the longer a system like this gets abused without correction, the worse off society will be when the day of reckoning arrives. So far we have managed to escape the wrath of a derivatives tsunami and not have a financial meltdown. We were fortunate to escape the Long Term Capital crisis but, at some point, however, we will not be as lucky as we have been in the past. After all, our government is financially strained and a path towards fiscal responsibility does not seem imminent.
It could very well be that the next big financial crisis will test the tensile strength of our financial system, which would almost certainly have ripple effects on global markets. Clearly, the underlying problem needs to be fixed now before it is too late.
A change needs to occur in how profit is accounted. Under the current system, the "marked-to-market" profit is taken on day one minus some relatively meaningless reserve number. I suggest that booked profit should progress with time. So most, if any, profit will be taken at maturity, less the preceding year, and so on. Thus, economic reality will be better reflected than the present fantasyland approach. Of course, this would ipso facto mean lower bonuses for traders and everyone else involved, at least in the front-end of the trades. But maybe then more thought would be given to exactly what types of risk should and should not being taken on behalf of shareholders.
