Off Topic | How Not To Discourage Banks from Short Term Trading

Lately we have had a lot of talks about Volcker repeal or replace. Does Volcker rule do what it is supposed to? Is it good or bad, and for whom? There are many issues, lobbying and conversations going on right now. Here is the latest proposal from Harvard Law School:

To achieve the objectives of the Volcker rule, we propose that banks be prohibited from basing compensation on trading-based profits. Our prohibition would encompass both ex ante compensation on trading-based profits (such as contracts or non-legally binding representations that the individual’s pay will be tied to their trading profits) and ex post compensation (such as discretionary bonuses the amount of which set based on a trader’s trading profits). Violations of this rule would result in a fine to the entity, claw-back of the individual’s impermissible incentive pay, and potential criminal liability for intentional violations.

The essence  of the argument from the authors are:

1. Banks compete in the securities market with other banks and firms to make short term trading profit (the target of the rule). Since this is a zero-sum game, only those banks who are able to attract top traders are able to turn in a positive profit, while others will be discouraged (by potential losses).
2. Since banks also compete in the labour market - i.e. to attract trading talent, banning profit-linked compensation will force talented traders to hedge funds.

Wham! together, the end result is banks getting second-tier trading talents who must compete against the first-tier traders from hedge funds and will lose money in the zero sum game that short term trading is. Hence banks in general will be discouraged to trade short term at all.

There are some serious issues with this proposals and authors' understanding how short term trading, compensation and banks work in general.

Firstly the way banks and hedge funds make money can be significantly different. A top-tier trader in a bank will not necessarily be a top-tier in a hedge funds. In short term trading, there are three ways to make money - 1) You have superior information of who owns what and who wants to trade which way 2) have a balance sheet advantage - to overwhelm markets or to hold your ground or 3) have superior analytical capabilities (better guts, models AI, whatever for short term price prediction) and/or pure trading skill.

Banks usually excel in #1 and #2 because of their dealing role (may be not #2 much anymore, but also they do not have to cross the bid-ask spread). Hedge funds have limited access to these information and balance sheet advantages, but are supposed to have an edge in #3. Many top traders from a banking set-up fail in a hedge fund environment because of this. The trading and making money work differently.

So even if banks lose out top trading talents to hedge funds, by no means they will lose their edges that they specialize in (more true for OTC-heavy asset classes like fixed income and less applicable for exchange-heavy asset classes like equities). The advantages belong more to the seat than the man (or woman as the case may be) occupying it.

And then the compensation scheme itself is weak. The easiest way to link trader's incentives to performance - where you cannot directly link it to trading profit - is to tie it to job security. Hire top talents with a very high fixed compensation. Prune the second-raters in next cycle. Rinse and repeat. The top talents will be attracted  - if they are indeed better, they will know they can perform. A compensation scheme linked to trading profits is a series of call option on trader's PnL. Tweaking this to high fixed compensation is similar, just a series of digital calls (instead of a vanilla calls), with a knock-out feature (based on trading profit).