An out-of-control industry

Subject: Critical review of « Traders, guns and money » by S. Das

Assignment for the « Management & Motivation » course, realized by: Aude MORIZOT, Charles POZZO di BORGO, Eva SASSI, Paul SOUDE, Aurore THEBAULT and Théo VERUT

Grade: A-

I. An out-of-control industry

The introduction was conducted with the help of Michel P., Head of Operational Risk Management at Banque de France. We wanted to know why and how the financial industry is so complicated to manage.

The financial sector is an “out-of-control industry”. The market’s activity is a sector which is strictly regulated. Each operator typically operates in markets that are peculiar to it, and within the limits allowed. Indeed, setting limits on banking floors is a key point.

Currently, there is a wide scope of financial value, extremely difficult for an individual to manage everything, so they specialize. They end up knowing much more than their boss. Control of the activity of a trader then becomes extremely complex, because the trader knows much more things than his manager. The activity on banking floors by the very nature type of financial instruments is very complicated. All the IT tools in place

are also complex. During the Kerviel affair, there were 300 IT certifications. Moreover, for the last few years, interest rates have declined, so banks are pushed to go on risky commodities and trades (more profits). However, human factor is the major part in risks. (As we have seen with the study cases of Nick Leeson and Jérôme Kerviel).

We notice that a juxtaposition of those factors encourage a lack of control in the financial sector. So the different levels of internal control is complicated to implement (by an interview of Michel P., Head of Operational Risk Management at Banque de France)

We read an inside book of the business of trading and marketing derivatives. It explains very well the frighteningly central role that derivatives and financial products played in the global crisis (from the summary of the book « Das (2006) Traders, guns and money. FT Prentice Hall, Pearson Education)

 

II. Satyajit Das

Satyajit Das is an international specialist in the area of financial derivatives, risk management, and capital markets. He works as a consultant to banks and other financial institutions in Europe, North America, Asia and Australia providing advice on trading, pricing and risk management of derivatives transactions.

Satyajit Das was born in Calcutta, India in 1957 and now lives in Sydney. He holds Bachelors’ degrees in commerce (Accounting, Finance and Systems) and Law from the University of New South Wales and Master’s degree in business administration from the Australian graduate school of management.

Satyajit Das is well known in Australia, Asia, South Africa and Europe as an expert in the field and recognised for his capacity to communicate complex financial subjects and trends in simple non-technical language.

 

III. Summary

Definition of « derivative »:

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

This book on derivatives, by Satyajit Das covers almost all the aspects of the arcane world of derivatives and narrates the author’s experiences from his personal career as a derivatives trader.

Traders, Guns and Money is a wickedly comic exposé of the culture, games and pure deceptions played out every day in trading rooms around the world. And played out with other people’s money.

A sensational insider’s view of the business of trading and marketing derivatives, this book explains the frighteningly central role that derivatives and financial products played in the global financial crisis.

This worldwide bestseller reveals the truth about derivatives: those financial tools memorably described by Warren Buffett as « financial weapons of mass destruction ».

Traders, Guns and Money will introduce to the player and the practices and reveals how real money is made and lost.

The global financial crisis took almost everyone by surprise and even now new problems keep appearing and solutions continue to be elusive. Satyajit provided a highly prescient insight into the structure and risk of the world financial system exposing the problems that are becoming readily apparent.

The main focus of the book lies in the interesting explanation of how investment banks and market dealers use structured derivatives to play around with the under informed clients and exploit them for money. From selling over-leveraged derivatives to repackaging toxic assets, the author exposes the insider tricks that dealers and traders have been using all these years at the expense of investors.

« Traders, Guns and Money » contains various stories fictionalised but supposedly based on what really happens.

 

IV. Link between the book and the issue

In the book, Das writes on the lies. So you have the beautiful lies (the “sell” side) and the true lies (the “buy” side).

  • The “Sell” side: the job of a sell-side research analyst is to follow a list of companies in the same sector, and deliver regular research reports to the firm’s clients. As part of this process, the analyst build Business Models in order to get the firm’s financial results. So he’s speaking with customers, competitors, suppliers… The job of a sell-side analyst could be related to a high-priced travel agent. The most important for this study is to see that companies will often restrict access to management by those analysts who do not bend their line of conduct. They have to sell to clients, it’s the way banks and the traders make money. In fact, beautiful lies are the lies that people like to believe. Quoting Das: “They are salespeople – they lie to clients. Traders lie to sales and to risk managers. Those last lie to the people who run the place”. So managers run the place. And the people who run the place lie to regulators and shareholders. It’s a vicious circle. According to Das, in its company, the quants (scientists) were trying to develop a lying model!

To explain this kind of model, we have an example of a municipal debt models (which is easier to understand):

Many municipalities have a lots of problems with their municipal debt. This is in part because of the big banks taking advantage of them, but it’s also in part because they often lie with models.

Specifically, they know what their obligations for pensions and school systems will be in the next few years, and in order to pay for all that, they use a model which estimates how well their savings will pay off in the market, or how they’ve invested their money.

But they use vastly complicate numbers in these models, because that way they can minimize the amount of money to put into the pool each year. The result is that pension pools are being systematically and vastly under-funded.5

  • Then you have the “buy” side: those are the customers, corporations and investors who trade derivative with banks. This is a world of true lies. Actually, the buy side think that the sell side lie (they think that dealers lie), and the sell side thinks that they are smarter than the buy side (they think that clients lie).

Back to financial sector, senior management leads traders, salespeople and support staff into battle. The leadership’s contribution is strictly “strategy” or “business models” (from Das). The management is very complicated: there are more chairmen and vice chairmen than any “reasonable” organizational structure could require. Das compare banks as “the last feudal kingdoms”. Their key lieutenant are considered as “Ronin who roam financial markets ready to ally themselves to any warlord for a share of plunder”. We see well that the hierarchy is very large and strict, and it is not the place to apply a management theory for example. This example also portrays the lack of motivation and commitment towards the company traders belongs to, and betrayal can happen any time.

Moreover, you have a “golden rule” in the banking strategy which is “if you make gold then you can make the rules”.

This last few years, changing financial markets necessitated professional management. However the system of progression in firms does not create good managers. The Peter’s Principle says “everyone is promoted to their highest level of incompetence”. According to banks and derivative business, that means that if a trader succeed a lot in its company, he will have lots of responsibilities (too much by Das) of management. So there is a problem because trading and management are not the same, in addition of all the lies that traders make. It’s paradoxical.

By the way, when a competent trader is promoted, he can’t refuse the promotion as he fears working for someone he can’t stand. So he’s going to hate its new job, feels insecure in it and surrounds himself with friends to protect himself. As Das says, “the feudal kingdoms are perpetuated”.

 

V. Conclusion

To put it in a nutshell, risk management is generally a fig leaf (a mirror) which management and boards of directors hide. Despite the amount of money spent (accentuated by the financial crisis), few serious risk management takes place. It is like most corporate governance: the triumph of form over substance.

Traders and banks take risks to make money and risk management is about measuring and controlling risk as we say before. Wouldn’t it be simpler to stop trading? Even if you want to manage risk, derivatives just rearrange it. Risk management instruments bring their own risks.