Why don’t rogue traders ever make money? Question answered.

Huge rogue gains are statistically possible, but they’re not incentive-compatible.

My friend Who Does This Stuff For A Living points out that my reasonable-sounding question actually has a perfectly straightforward answer: traders have an incentive to “go rogue” only if they’re losing money, and that incentive disappears once they make it back. It’s only the losing positions that keep getting doubled-up.

UBS’s $2.3 billion unauthorized trading loss is back in the news. Yesterday, CEO Oswald Grübel accepted responsibility for the loss and resigned.

When the loss was reported last week, Mark asked, “Why don’t rogue traders ever make money?”

“This should be statistically impossible,” Mark suggested. “Since risks are symmetric and transactions costs tiny, if there were really trading strategies that could reliably lose billions of dollars, you could make huge sums just by making the opposite bets. This suggests to me that big banks only classify trading activity as ‘unauthorized’ when it loses huge amounts of cash.”

I disagree and think that a simple model of how banks monitor and compensate proprietary traders explains why there aren’t $2.3 billion unauthorized trading gains.


1. Proprietary traders are given a certain amount of capital to trade at the beginning of the year. Thus, if they have gains during the year, they have more capital to trade; if they have losses, their available capital declines.

2. Traders are paid a year-end bonus based on their annual trading profits.

3. Banks have risk control systems that set risk-taking guidelines and attempt to monitor trading. If a trader is observed making larger or riskier bets than is permitted, he may have his capital reduced, he may forfeit any bonus he would otherwise be due, and he may be fired or suspended. The risk control rules also include per-trade and per-period stop-loss limits. If a trader exceeds a stop-loss limit, he is shut down, either temporarily or permanently.

4. The longer unauthorized trading continues, the more likely it is to be detected.

There are three traders at a bank: A, B, and C. Six months into the year, A has trading profits, B is flat, and C has losses. None has engaged in rogue trading thus far. How do their incentives to engage in rogue trading differ?

Trader A: Because A has profits, he has accrued a bonus and is effectively trading his own money alongside the bank’s. Good alignment of interests as far as these things go.

Trader B: Weaker alignment because B has no accrued bonus. If B loses money over the next 6 months, none of the losses comes out of his pocket. However, B earns a bonus on the first dollar of profits.

Trader C: Poor alignment. Because C is under water, he can only earn a bonus if he makes a big profit over the next 6 months. He has an incentive to swing for the fences. And because he has losses, he has less capital to trade, making it very difficult for him to earn a big profit without taking greater trading risks than the bank’s risk control rules permit.

You see why massive rogue trading gains are unlikely? The losing trader, C, has the strongest incentive to cheat, and also the strongest incentive to make big bets. If he starts cheating, then the longer his losing streak, the more he will bet, and the greater the chance he gets caught. Moreover, if C engages in rogue trading and somehow gets back into bonus territory, he has an incentive to stop screwing around and return to making small, authorized trades.

It still may seem puzzling that a trader can lose billions. Losses on that scale require a losing streak that would seem to violate the laws of chance. And financial markets seem efficient enough that there shouldn’t be trading strategies that reliably lose—otherwise, as Mark pointed out, one could make a bundle by adopting the opposite trading strategy. However, UBS-like trading losses tend to be neither random nor systematic in a way that one could reliably profit from taking the other side of the loss-generating trades. The losses are ex-ante random but ex-post systematic.

Imagine a trader who in February 2011 believed that the yield curve would steepen, and he expressed his view by going short 10-yr treasuries and long 2-yr treasuries. He started to lose money, began hiding his bad trades, and doubled down after losses like a Martingale bettor. At each point in time, the outcome of the next bet appeared random—when the yield on 10-yr treasuries reached 2%, was it obvious the yield would go to 1.7%?—so there was no ex-ante free lunch from taking the other side. But with the benefit of hindsight it’s clear that the 7-month flattening of the yield curve was not a random walk.

Now imagine a trader who decided to bet the other way. Ex post, he turns out to have a systematically winning strategy. If he doubled up his winning bets the way the “rogue” doubles up his losing bets, he’d make ton of money for the bank.

But he’d also get himself fired. There’s no way he could conceal from his bosses that he achieved his huge win by grossly violating his trading limits. The laws of chance make huge rogue gains possible. But they’re not incentive-compatible, so they don’t happen.

Gotta love blogging. All you have to do is express a random ignorant opinion, and an expert appears and straightens you out. It’s like the reason a hiker should always carry a deck of playing cards; if he gets lost, he just sits down and deals himself a hand of Solitaire, and someone is certain to come along to tell him to play the black jack on the red queen.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: Markarkleiman-at-gmail.com

15 thoughts on “Why don’t rogue traders ever make money? Question answered.”

  1. The three traders remind me of three gamblers at blackjack table…
    With apologies to your friend, there is nothing here that Reno hasn’t already taught us…

    And for some reason, I am also reminded of a terminal paragraph from a recent Harold Meyerson post:

    In a country where 50,000 factories have been shuttered in the past decade, and where unemployment exceeds 9 percent, the UAW’s contract is a signal achievement. But a country where 50,000 factories have closed in the last decade and where unemployment exceeds 9 percent is not a country where workers, no matter how good their union, can win genuinely good contracts.

    Once upon a time didn’t Wall Street actually help build something up in this country?
    And now our brightest want to be traders at the Wall Street casino? And do what?
    Privatize social security so they have more leverage to trade with?


  2. There is an amusing story floating around about some genetic specialists in virology. They could not figure out some twist in why something happened, so they designed an internet game and released it. Three weeks later, the gamers had pretty well solved the problem.

    Now what occurred to me was: Why can’t an economic model called Total Capitalism be made into a free on line game and then find out what theories of economics are totally invalid.

    I suspect that a game like that would immediately show how gambling on markets really works.

  3. I still say that when a trader “loses” a billion dollars, some other trader(s) “make” that billion dollars. Real money does not disappear like small change in the sofa cushions; it merely gets transferred from one account to another.

    The only thing you can do to “make” money in the financial markets is to buy low and sell high. Your counterparty in each case has to buy high and sell low. You can’t “trade” without trading with somebody; you can’t win what some other fellow does not lose.

    From the perspective of a single trader, or his firm, the concept of “making money” — and its opposite, “losing money” — is perfectly real. What’s unreal is the implication that somehow, if nobody goes rogue, EVERYBODY in the financial markets can “make money”; that ALL traders can buy low, sell high, and “earn” bonuses; that The Financial Market as a whole “creates wealth”. That the financial market makes some traders rich is undeniable: look at their mansions and their yachts and their bank balances. But the cash money the traders (and their bosses, and their investors) take out of The Market to buy yachts and mansions with had to be put into The Market by SOMEBODY. It had to come out of somebody’s bank balance.

    It’s easy to fixate on the billion dollars that a rogue trader “loses” out of the net worth of the investors whose money he was gambling with. His investors’ net worth dropped by an aggregate billion dollars. But let’s not lose sight of the fact that some other traders’ investors’ net worth rises by that same billion dollars. Those other traders, non-rogues of course, “made” money for their investors, but they no more “created wealth” than the rogue trader “destroyed wealth”.

    It seems disproportionate to get all het up about a “rogue” trader who “loses” money in a financial system wherein the “honest” traders “make” money by collecting it from the losers.


  4. Tony P,

    Both parties are playing with other peoples’ money (OPM). The gusher of transferring wealth upward is the gift that keeps on giving and losing traders and their counter-parties can play forever their “bet a million Gates” strategies, because they are just trading back and forth a larger and larger portion of the economic pie. Therefore, in aggregate, this cohort cannot possibly lose as long as the game stays rigged.

  5. Tony P & bobbyp,
    Certainly the Wall Street Game has devolved into a huge cassino to a great degree but let’s recall there is such a thing as value added. A company can in theory sell stock to investors and use that money to build a factory to make doors out of raw materials and sell those doors to people who are building houses or office buildings or quirckey tables made out of doors (I knew a guy who did that & and they sold quite well).
    All this money has to come from somewhere and that place is our imaginations. If economy were really a zero sum game there would be no money at all because it could never have been created in the first place.
    The trouble comes from a lack of regulation to assure that money creation is tied to wealth creation (value added). The devil is in those details and money is indeed a toy of the devil.

  6. To blow my own horn, I believe you will find the argument made by your friend who does this for a living as a comment on the original post.

  7. Anomalous,

    Keep in mind that “the economy” and “the financial markets” are not the same thing. The economy is the arena in which people make tables out of doors, and semiconductors out of sand, and so on. The financial markets are, by definition, an arena in which people do NOT do things like that.


  8. There’s another possibility as well: make piles of money openly, and you have a chance for promotion to positions with (directly or indirectly) larger official risk limits. If you believe in random-walk theory, that would explain how so many people not labeled as rogues ended up taking down entire divisions or firms.

  9. Tony P,
    My point is that the finacial markets are supposed to exist to facilitate the economy. Your quotation marks point up a distinction that only exists because of stupedously poor regulatory policy.
    I know, I know, that’s the way the world is. I always hated that particular saying: “That’s the way the world is.” I guess I’m just a starrey eyed optimist who thinks if we can all just agree on what is obvious that our elected officials may go ahead and pass laws that are obviously needed. I know, I know…

  10. Tony P.: “Keep in mind that “the economy” and “the financial markets” are not the same thing. The economy is the arena in which people make tables out of doors, and semiconductors out of sand, and so on. The financial markets are, by definition, an arena in which people do NOT do things like that.”

    The financial markets, at least in theory, are where people lend money to someone who wants to buy a sand-to-semiconductor transformation apparatus. Frequently, especially in recent decades, they go on to build giant houses of cards with no real economic purpose on top of the original loan.

  11. Isn’t expressing random ignorant opinions what you are all about? In fact, that’s what’s great about reading this blog (and watching you do a cost benefit analysis), you are very seldom accurate but you are ALWAYS certain!

  12. Excerpt Below from: http://www.stockhouse.com/community-news/2011/sept/22/the-case-for-hyperinflation-in-the-u-s

    “Paul Krugman at the New York Times has been wrong for years and years about absolutely everything yet he is still thought of by many people as being a ‘smart’ economist – despite his calling for a housing bubble after the tech bubble and now having resorted to stating that the best way to get the American economy on track is through a massive, fake alien invasion.”

    “Remember, that almost every US economics PhD, every major economist at most banks and people like Bernanke and Krugman will all have to admit they were all fools in order for them to stop with their Keynesian witchcraft. Most white, older men who look in the mirror and see they are monsters rarely admit their flaws… they tend to take us all down into hell with them rather than, as the Japanese say, ‘lose face’.”

  13. There are no rogue traders, there are only rogue banks
    Posted By Barry Ritholtz On October 2, 2011 @ 7:41 am In Apprenticed Investor,Bailouts | 15 Comments

    This is my Sunday Washington Post [1] column from last weekend:

    There are no rogue traders, there are only rogue banks

    In 1995, derivatives broker Nick Leeson of Barings Bank engaged in “unauthorized” speculative trading. The massive losses — 827 million pounds — led to the collapse of Barings, the oldest investment house in Britain.

    In 1996, another rogue, Sumitomo Bank copper trader Yasuo Hamanaka, lost at least $1.8 billion. Some reports put the true losses at $4 billion.

    Then, in 2008, Jerome Kerviel of Societe Generale lost 4.9 billion euros — about $6.8 billion.

    And just last week, UBS suffered a $2.3 billion hit connected to an alleged rogue trader.

    As history teaches us, there are no rogue traders; there are only rogue banks.

    Here’s a news flash: If you issue credit, your working assumption must be that there are unqualified people who will try to borrow money from you. It is the job of every lending facility each and every day to separate the qualified borrower who has the capacity to service that debt from the unqualified borrowers who do not. This is why there is no such thing as a predatory borrower — banks must assume that all borrowers are predatory and protect themselves. This is why lenders — at least before 2002 – inquire about income, employment history, credit scores, other debt, etc., before making a mortgage loan.

    Similarly, if your business involves the use of leveraged capital for speculation by your employees, then it is your job to know which, if any, of your people are not competent. It’s a simple mathematical fact that some of your traders will take losses; in some cases, enormous but manageable losses. Your job is to identify these people and move them to other professions.

    There will be a small number who will try to hide their inabilities. Your job is to separate the qualified from the unqualified, to watch over the full lot of traders and speculators in your employ. Toward that end, you will establish trading limitations, leverage constraints, risk parameters. Traders must stay within the limitations you impose on them: money lines, maximum drawdowns, loss limits.

    Thus firms that highly leverage their capital to put it into the hands of a few thousand employee speculators have a crucial job: They must ensure that capital is being precisely and properly managed. They must make sure that risk levels are tolerable, that proper controls are in place, that their IT systems and internal technology can track what is happening, in as near to real time as possible.

    This is not easy. It is a complex set of processes that requires constant vigilance. It must be reflected in the corporate culture from the top down. And it becomes more and more complex as the size of the organization grows. The assumption must be that every employee is a potential rogue trader.

    Banks are supposed to have expertise in preserving capital and managing risk. If they cannot discharge those simple duties, then perhaps they should not be in the business of finance. Most of all, they should not be engaging in behavior that puts taxpayer money at risk.

    Anyone who runs a shop that has a proprietary trading desk is obligated to do everything in his power to prevent that single employee from bringing down the company. It’s not too hard to see that anyone who earns a bonus by risking the firm’s capital is a potential disaster.

    With this backdrop, how is it that we seem to have a major rogue trader pop up every year or so? The simple answer is, a rogue trader who nets massive losses is a complete and utter failure by the bank’s management. UBS was unable to track its capital on a timely basis, as its London trader hid losses for more than three years. So much for real-time supervisory tracking.

    The arrest of a rogue trader is a red flag. The discovery of the fraud is a company admission of being poorly managed. The board of directors should be holding senior management just as responsible as the trader for the losses. They may not have committed the same legal fraud — hiding the trades — but they should be sacked for gross dereliction of duty.

    Understand what this means within the broader context of our financial sector’s not so innocent foibles: Any firm that hires “robo-signers” is just as bad as a firm that has rogue traders. Both actions are an indictment, an admission of failure and of managerial incompetence. Each illegal act represents a crucial failure of risk management, of legal compliance, of the ability to do jobs safely and within the law.

    In an era of bailouts on the backs of the taxpayer, it points to a simple reality: Firms must decide whether they are going to sacrifice profit in pursuit of safety, or sacrifice safety in pursuit of profit. Whatever they decide, it is not the responsibility or obligation of taxpayers to backstop these choices.

    Consider the choices made by management: The collapse of firms such as AIG, Bear Stearns and Lehman Brothers were caused by the same sort of poor judgment as UBS’s $2 billion in losses — only the rogues gallery there included the senior-most managers of the firms. Alan Greenberg exhorting his staff to focus on reusing paper clips, while the mortgage syndication division lost billions of dollars. Dick Fuld surrounding himself with yes men while the firm’s leverage and risk exposure went through the roof. Tom Savage, president of AIG’s Financial Products, calling derivative underwriting free money.

    Paul Volcker, arguably the greatest central banker in history, has persuasively argued that proprietary trading should not be part of the insured depository banking sector. I utterly agree with Fed governor Thomas Hoenig, who has described the banking sector as “more akin to public utilities” than independent entities. Want to be independent to pursue proprietary trading? Let’s drop their FDIC insurance and see how far their reputations carry them.

    The next crisis — the one after the present one in Europe — is where I expect to see the ultimate damage wreaked by rogue bankers.

    The bailouts have created a moral hazard, where leveraged speculators and rogue bankers know that the state will bail them out. This is unacceptable. There is no reason that taxpayers should be responsible for any rogues, traders or bankers.

    Perhaps UBS’s failure [2] to prevent this did us a favor. It points out that Volcker is right: Any firm that can blow itself up should not qualify for taxpayer guarantees. Lenders, underwriters and mortgage originators are in the business of using their capital to earn a fair return safely. That government-backed insurance should be available only to depository banks, not firms associated with speculative traders.


    Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation [3]” and runs a finance blog, The Big Picture [4].

    Article printed from The Big Picture: http://www.ritholtz.com/blog

    URL to article: http://www.ritholtz.com/blog/2011/10/there-are-no-rogue-traders-there-are-only-rogue-banks/

    URLs in this post:

    [1] Washington Post: http://www.washingtonpost.com/business/there-are-no-rogue-traders-there-are-only-rogue-banks/2011/09/20/gIQA3sCxtK_story.html
    [2] UBS’s failure: http://www.bloomberg.com/news/2011-09-24/gruebel-quits-as-ubs-chief-ermotti-interim-successor-bank-to-reduce-risk.html
    [3] Bailout Nation: http://www.amazon.com/gp/product/0470596325?ie=UTF8&tag=washingtonpost-20&linkCode=xm2&camp=1789&creativeASIN=0470596325
    [4] The Big Picture: http://www.ritholtz.com/blog../

Comments are closed.