Thursday, February 28, 2013

"Why It’s Smart to Be Reckless on Wall Street"

Found this while looking for a Miguel Nicholelis post at SA. I always forget if that's propinquity or serendipity.

From Scientific American:

Here is a guaranteed way to get paid well if you work on Wall Street. Find a best friend at a competing bank or hedge fund and take opposite sides of the same large bet. In one year’s time one of you will have a huge profit and get paid well. The other person will have lost and perhaps be fired. The sum of both your profits will be zero, but the sum of what you get paid will be positive. Split the pay.

This scheme is one of the more fanciful ways to exploit Wall Street’s compensation structure that pays absurdly well in the good years and just okay in the bad years. Losing money never means having to give anything back.

That asymmetry in pay (money for profits, flat for losses) is the engine behind many of Wall Street’s mistakes. It rewards short-term gains without regard to long-term consequences. The results? The over-reliance on excessive leverage, banks that are loaded with opaque financial products, and trading models that are flawed.

Regulation is largely toothless if banks and their employees have the financial incentive to be reckless.
How does Wall Street pay its employees? At the end of each year traders are paid a base salary and a bonus. The bonus, which fluctuates wildly, is usually a percentage of a trader’s profit. Some companies even pay a contractual amount, often between ten and fifteen percent. The average bonus of all employees is about three hundred thousand dollars but payments of $1 to $15 million are common. If traders lose they still get their base, often around two hundred thousand dollars. If their loss is great enough, they are fired. They never have to return money.

The incentives are clear. If you make a bunch of money you get personally wealthy. If you lose then you just go home and look for a new job....MORE
The play-both-sides-of-the-bet idea sounds similar to some comp scams that craps players use.