Is it smart to be stupid?
Are the incentives in trading and financial markets so skewed that it’s profitable to be foolish and reckless? It sure seems so. One of the frequent targets of financial reformers is proprietary trading—the infamous “prop desk.” At this work-station, young men and women stare at multi-screen monitors all day, divining relationships between volatility, forward rates, overseas markets, and other traders. The goal is to get 15 seconds to 15 days ahead of the next trend, and ride it to a profit.
The pay-structure at the big banks and hedge funds creates a moral quagmire. Traders earn a base salary, enough to live comfortably in a big city. But they also receive an annual bonus, typically 10-15% of their trading profits. Have a good year, and that bonus can total tens of millions of dollars. Have a bad year, and you may not get a bonus. You may even get fired. But you never have to pay back your prior earnings.
The problem is the asymmetry: win big and you can get fabulously wealthy; lose big and go home and look for a new job. And it’s a pretty simple system to “game”: start small, build credibility, and get your trading limits expanded. Then bet big–really, really big. If you win, you may just have earned enough to fund a lavish retirement, your children’s and grandchildren’s college education, and a new hospital wing in your name. Lose, and—perversely—you may have gained enough credibility to start your own hedge fund.
Wall Street is littered with traders who have blown up their employers, their clients, and much of the financial landscape. As long as traders can just walk away from huge losses, they’ll just keep blowing things up.
Douglas R. Tengdin, CFA
Chief Investment Officer