Understanding the Market

Every few years there is a story of a trader who loses huge amounts of money; most recently, Jerome Kerviel at Soc Gen, but there were many before him. The magnitude of these losses is a great mystery: how can one person lose Euro 5 billion? Didn’t someone realize that there was a problem when M. Kerviel lost his first billion? I believe that there is an answer to this question that lies at the heart of financial regulation.

Traders are similar to professional football players. The best football players will help their club earn championships and in turn will be paid huge salaries. There is tremendous competition to become a top player

, and players will use every available technology (such as equipment and training) to become faster and more powerful. Referees are not so highly rewarded. While a top referee may make a good salary relative to other professions, the reward is nothing like that of a football player. Few spectators decide whether or not to attend a game on the basis of who will be the referee; while many will argue at great length about the quality of the decisions the referee made

, referee errors are considered a part of the game, and clever players will exploit a referee’s shortcomings. Often one gets the sense that referees fail to accurately make decisions in part because they are not at the same talent level as the players on the field.

Traders

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, instead of scoring touchdowns on the field, take risky positions in order to make profits. They adopt complex trading strategies combining computer models and their own intuition. But banks place limits on the traders, to minimize the chance of a large loss. The risk managers can be seen as referees, enforcing the bank’s risk limits. Risk managers, like referees, are seen as a necessary burden. The risk manager is often viewed as a cost-center, bringing no added profit to the firm.

While we are likely never to know the full story of M. Kerviel (nor that of Mr. Leeson, the trader who lost so much money at Barings Bank), the outline is fairly clear. Kerviel knew the “back office” systems fairly well, having started his career in the part of the bank that accounts for traders’ activities. Kerviel was supposed to make small bets, but wanted to make larger bets to show his trading skills to his superiors. He used his knowledge of the bank’s accounting systems to conceal the size of his positions, allegedly avoiding the normal control procedures. Whatever the details, it is quite clear that Kerviel was a step faster than the referees, who were unwilling or unable to restrain his behavior until he had large losses, which were subsequently multiplied as the bank may have had to quickly sell off his positions at a greater loss.

There is no obvious solution to either the referee problem or the trader problem. Football leagues are willing to spend some money to improve the quality of referees

, but only just enough to keep fans watching, and not enough to have perfectly refereed games. Every few years an important game will be decided by what appears to be an incorrect decision by a referee and some fans will pay less attention to that sport in the following years.

Banks need to allow creative traders to trade, otherwise they would lose these employees to other firms (note how many traders have already left traditional financial institutions for private equity and hedge funds). The risk is that every few years a financial institution will disappear, a risk that many institutions seem to think is worth taking.

This entry was posted on Tuesday, June 24th, 2008 at 7:55 am and is filed under Markets. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.