February 10, 2002
Surviving a mauling in the pitPosted in · 1 comment ·
‘So Paddy, what the fuck do you know about the fucking French market then?” This was my introduction to the pit’ on January 4, 1994.
The pit, as the sunken banks of foreign exchange desks were called, was a terrifying place for an inexperienced 26-year-old Irish economist. Every day at 7am, in front of the largest trading operation in the City, I had to convince these growling, hung-over, bacon-buttie chomping traders that I knew where the currency markets were going that day.
Nothing, not even live TV, is as nerve-racking. However, by the time I graduated to the FX traders’ five-a-side soccer team, “Mick” (as they usually called me) “was all right” and the traders were no longer scary masters of the universe.
More typically, they were products of a very perverse working environment in which greed and fear are the dominant characteristics. A foreign exchange trader is a product of his or her environment.
This weekend, the losses at AIB, as with Barings, Daiwa and Sumitomo, are being characterised as the single-minded efforts of a rogue trader. All week there has been talk about compliance procedure, the middle office, supervision and risk management systems. Politicians and various board members have pronounced on the need for tighter corporate governance and control over traders, while the press is fixated on the type of individual involved.
The subtext is that this is a story of a personal vice, usually greed, on the part of the trader or his managers or both. All this may be true but it misses the point. Against most expectations and financial theory, there is no explicit pattern that links such large trading losses. Large losses have neither occurred in the weakest institutions nor in the most esoteric financial products.
Both Nick Leeson and John Rusnak were using very straightforward instruments known in the trade as “plain vanilla” trades. Nor is there any pattern in terms of the types of people involved or their academic or intellectual qualities.
Much is made of the wide boy social background of traders, but the so-called rogue trader does not fit any social stereotype. The fact that Rusnak was married with kids, while Leeson partied like a demon does not matter. All rogue traders have energy and ambition, they are enthusiastic and smart yet all appear unable to exercise the self-restraint characteristic of maturity. Nothing in their current working environment encourages traders to develop mature, reflective thought: on the contrary, almost everything discourages it.
The ultimate objective for all markets is efficiency and openness. Regulators want efficient, transparent markets free from insider dealing, where the customer gets the best deal.
From the trading perspective, the problem with this is that the more open, transparent and competitive the market, the lower the profit margins on each trade. Lower margins imply that a trader has to take bigger risks to make stellar returns.
In short, the goals of the regulators and politicians — efficient, open and transparent markets — are the antithesis of profitability and success as seen from the traders’ perspective.
Therefore, traders must use more borrowed cash on each position in the open market or they seek opaque, secretive high-margin markets such as the emerging markets, certain structured products and some of the more exotic commodities.
The fact that traders’ interests and those of the regulator diverge should not be a problem because so many markets are now transparent and open to regular scrutiny. Why, then, is it so difficult to manage traders?
If there is not pattern in terms of the type of people or products involved in large trading losses, is it the trading environment itself that creates a problem?
Most traders trade in a pit, sitting almost on top of each other where everyone can be seen and heard and all calls traced and deals marked. There is no privacy whatsoever and the trading day is characterised by moments of intense stress and uncertainty, moments which most of us in our `normal’ lives would experience as fear.
The markets are not designed as places of deliberation, reflection or thought, apart from a few quick calculations followed by an angry outburst. Traders rely on instinct, on a sense of the direction of the herd, mindful of the constant threat of competing predators.
This environment is not dissimilar to the basic ‘Fight or flight’ response of animals. It is an environment almost guaranteed to bring out the most primitive feelings and behaviour and also one that champions the `star’ trader, the one with the biggest balls.
This explains the stereotypical antics of City traders, the loud, macho, ‘Get your tits out’ culture of ferocious boozing and eating. It also explains the vulgar displays of wealth, the incessant practical jokes and the gang-like laddism that is commonplace.
More importantly for institutions, this sub-culture fosters an “us and them” mentality and a deep-rooted contempt for authority and management. Yet the principal management tool is to reward such behaviour and (in my experience at two of Europe’s largest investment banks) management is also petrified of upsetting star traders who can point to the bottom line and accuse management of being interfering bureaucrats.
Traders themselves are terrified of failure and focus only on cash as their reward. In sharp contrast to the relationship between trader and management, which can best be described as spoilt child and inexperienced parent, the standards demanded by board members and the regulators are those of the highest ethical behaviour. These include client loyalty, integrity, self-restraint, patience and an understanding of the wider interest of the financial community.
Given the wide disparity between the rhetoric of the board and the reality of the trading floor and the need for a bank to be seen to be tough on wrongdoers, the punishment meted out to traders is unusually harsh.
Typically, if a spoilt child steps out of line, the parent uses it as an opportunity to advise, guide and give the child the opportunity to learn from his or her mistakes. In financial markets, if a trader makes a mistake, the sanction is normally the sack.
In many cases, relatively minor offences lead to the trader being investigated by the authorities, leaving him or her bankrupt and with a stained reputation. Because of the pressure of success, excessive punishment and an understanding that management play by different rules, the last thing a trader in hot water will do is look for help. Normally, traders will attempt to conceal the problem by trying to trade out of difficulties, hoping the markets will reverse. They then hope to emerge as heroes, which is, after all, the fantasy of every gambler.
This is what Rusnak tried to do playing the dollar/yen market. A year ago, it might have seemed logical for the dollar to fall against the yen as the US economy was faltering and the Japanese economy could not get much worse. That suggested an early appreciation of the yen against the dollar.
This did not happen and the closer the margin calls on his original forward position came, the more desperate was his situation.
Arguably, Rusnak is no different to all my old mates in the pit: a product of a very strange world, feted by the bosses when things are going well and feeding many mouths at bonus time.
Yet at the first hint of a problem, the trader is accused of recklessness and abandoned by a management class that does not speak the trader’s rather colourful language.