Peter Martin
Whenever a rogue trader surfaces there is much murmuring about how banks need tighter controls. But the simplest solution to trading losses is never mentioned: stop trading. To most financial experts, this will seem absurd.
It is conventional wisdom that the vast surge in trading is a good thing. Well, it is not. We are collectively indulging in far more trading than the world needs - and more than is in the interests of the participants' shareholders.
Each day $1,200 billion (€1,370 billion) of foreign currency is bought and sold, and $580 billion traded in over-the-counter currency and interest rate derivatives. These figures include some double-counting, since many transactions involve simultaneous purchases and sales. But statistical quibbles cannot disguise the extraordinary rise in trading in recent decades.
Even the disappearance of euro-zone national currencies has reduced foreign currency trading only a little, and other markets have continued to grow at higher rates than gross domestic product or international trade.
Why is there so much trading? The participants underestimate the risk they run and overestimate the long-term rewards.
Individual traders are emboldened by the "trader's option" that gives them a huge potential upside in bonuses if a risky position pays off, against the downside of, at worst, having to find a new job.
But organisations can make the same mistake and financial institutions have particularly strong incentives to do so. Other income sources for international banks are drying up, now their core business of lending to companies has been taken over by the bond and commercial paper markets.
They also have a trader's option: if they are too big to fail, they can, in effect, gamble with government backing.
Clearly, an acceptably liquid market - one in which there is active trading, so you can deal in size without moving the price against you - is better than an illiquid one. But superliquid markets do not bring extra benefits.
Indeed, they may produce perverse effects such as a high degree of short-term volatility that makes trading seem more attractive - sucking in more briefly lucky fools.
It also encourages the belief that you can always trade your way out of a tricky position. Repeatedly this proves false in a crisis - a particularly damaging discovery for banks using risk models that assume a permanently liquid market.
If superliquidity is of doubtful value, consider the other costs of too much trading, such as operational risk. The $750 million losses attributable to John Rusnak, Allfirst's alleged rogue trader, are by no means a record. And, as AIB is discovering, a small trading business that goes wrong distracts senior managers from their core business.
These are just the publicly visible trading errors. Many others are concealed inside otherwise-profitable trading books. And because banks often lump together the profits of trading for third parties with their proprietary trading, the figures make trading look more attractive than it really is.
Some trading desks do seem to be capable of making sustained profits. But many others do not, once you adjust for capital employed, the risk of positions taken and the occasional operational disasters. In any case, the apparent success of trading strategies of some of the big banks is in part a mirage caused by survivor bias: unsuccessful operators go bust or merge, so all we see are the successful ones.
Of course, markets are an efficient way of setting prices and matching supply with demand. They provide banks with an effective way of managing their balance sheets to reduce risk. And when companies borrow from bond markets, not from banks, they reduce systemic risk in the financial system. But we could achieve these results without our vast oversupply of trading activity.
The solution to excessive trading lies in private sector hands. Shareholders must impose a valuation penalty on financial institutions that rely too heavily on trading. Managers must lessen the value of the trader's option. And we must persuade our sons and daughters that there is nothing glamorous about the trading life.
Mr Rusnak may do us all a favour, not because he failed as a trader but because even when he was successful, he lived such a resolutely suburban life. No glamour there; and a good thing too.
- (Financial Times Service)
