The Greg Smith Op-Ed, “Why I am Leaving Goldman Sachs,” in the New York Times caused quite a stir. For some it was an explanation that allowed them to connect the dots. Ah, now we know why this happened. However, we don’t think it was all that simple as “the culture changed” and would like to point out the very close relationship between bonuses, accounting and how clients are treated.
In the derivatives world that Mr. Smith worked in, P&L often comes over the course of years. A spread, sometimes small and sometimes not, is projected for the life of the transaction. That spread could be the function of equal and opposite trades done at a better price to close out the risk. It might be the result of hedges that traders anticipate will offset the risk based on their expectation about correlation. Some of those hedges may be dynamic and have to be adjusted over time. Or it might be based simply on the traders estimate, often helped with a model, of what the right market price for the trade is versus where it was executed. Each of those offsets has risks – be it counterparty, market volatility, systems/operational, or model risk. But that doesn’t stop derivatives traders from figuring out the present value (PV) of the profit streams and booking the anticipated P&L up front. Management accounting policies bless this arrangement.
Traders are paid on their profits. There is an understandable and predictable urge to book as much profit as one can as quickly as one can in order to get paid more. PV’ing P&L is one way to do that. But a lot can happen between booking and maturity, much of it not good. The mentality is often “out of sight, out of mind, let’s do the next trade”. In the meantime, trades pile up on the balance sheet that are asymmetric – the profit has been mostly taken, but if they turn into losers, all the P&L will have to get reversed and then some.
What will change this? Compensation structures on Wall Street — which is both the carrot and the stick — have already morphed radically, but more needs to be done. The fixed part of compensation – salaries – has gone up considerably at the expense of bonuses, the variable component (and not just because of lower revenue). Zero bonuses are not uncommon on trading floors these days and bonuses can be deferred. Clawback provisions on deferred bonus, which are designed to be management’s way of getting traders to pay attention to long-term profitability, are becoming commonplace. This is how it has to be for client interests to be the number 1 priority, and more can still be done.
The most significant missing piece in this puzzle of setting client needs first is accounting changes. Marking trades to market and taking P&L up front, before the cash is actually in the door, is a sanctioned accounting practice. Change the way that accounting is done to make a trade profitable for the long-term before its hits the P&L as such, and watch how fast traders move to make this happen.
As an example near and dear to our hearts, in the securities lending world, the incentives are a far cry from derivatives. As an agency business that focuses on short term deals where the profitability is split between the beneficial owner and the dealer, the risk and opportunities are very different. There aren’t a lot of “elephant trades” to hunt. The successful business model is and is supposed to be old fashioned: create long term annuity-like flows that are in the best interests of clients in the short and long terms. Those are best achieved with solid clients relationships based on mutual trust.
On the “a bit too close to home” / humorous side, you might want to read a Calvin Trillin New York Times column from 2009 on Wall Street. A Link is here.