The recent flap over Phibro’s Andrew Hall and his $100 million+ compensation package makes for good headlines, but fails to get at the essence of the real problem: the manner in which Wall Street trader compensation is calculated and disbursed.
But even more importantly, the talk of nullifying or modifying his contract simply because neither Citigroup (NYSE:C) nor the US Government like it brings with it dark and threatening implications. If contracts entered into legally and without prejudice are all of a sudden cast into doubt, the entire foundation of free and fair commerce is in jeopardy. Say what you may about a trader getting paid $100 million per year, but if you are a Citigroup shareholder: (a) you’ve known about this; (b) you’ve benefited handsomely from it; and (c) there are lots of contracts where Citigroup is paid a lot of money, and if they were nullified would bring grave harm to the firm. I wish muckrakers and whiners would use their brains and hold their tongues when talking about stiffing people pursuant to legally valid contracts. The issue should be “Are these contracts appropriate and do they create value for the firm?” and not “These pigs are getting paid too much money. We should tell them to go to hell.” Because once you can simply say “I don’t like this deal” and walk away, lawlessness and economic chaos is sure to follow. The Obama Administration should run as far away from this talk as possible, and even publicly stand behind the rule of law as an essential component of a free and fair society. As I tell my children: Think before you speak.
Back to Wall Street trader compensation. The issue is inextricably tied to risk-taking, where the Wall Street “heads I win; tails you lose” payout paradigm rewards excessive risks and places little to no premium on risk management. Further, given that current year cash payouts are a significant part of the trader compensation package, subsequent year losses have little impact on monies actually collected by the losing trader. It’s also important to note that Wall Street traders effectively start at zero P&L each and every year, institutionalizing a short-term mind-set that doesn’t create sustainable equity value for the firm. In short, the Wall Street trader compensation model is badly broken, in large part because of the agency effects of risking hundreds of millions to billions of dollars of “other people’s money” [OPM] with a grossly asymmetric payout function (e.g., shaped like a call option where the trader’s max loss is their base salary, while their max gain is effectively infinite and is a function of gross profits).
Like them or hate them, the hedge fund compensation structure has many positive attributes that can be instructive for Wall Street (especially when the lion’s share of the trader’s net worth is tied up in the fund):
- Diluted agency impacts. While hedge funds generally involve running large amounts of OPM, when much of a trader’s net worth is invested in the fund their risk-taking directly impacts their financial wellness. This is not the case on Wall Street, where traders don’t get to actively participate in their strategy on an ongoing basis.
- Compounding capital. As Wall Street traders get paid out on current year results, there is no concept of compounding gains from current year returns applied to prior years’ capital balances. This is a huge disincentive for prudent risk taking and an emphasis on making profits in all market environments. It encourages a “swing for the fences” mind-set on Wall Street since each year stands on its own. Hedge funds, conversely, permit capital balances to accrete upward and benefit from lower levels of volatility in their IRRs.
- Long-term perspective. Since hedge fund traders are generally only able to withdraw a small amount of their capital each year, they have strong alignment of motives with their investors. Sure, while it can be argued that a hedge fund trader can take on huge risk, try and kill it and simply close down and start again if it fails, the fact that significant partner capital is wiped out with poor peformance makes this a less-than-likely outcome.
Personal investment in one’s strategy. Compounding capital. Long-term perspective. This sounds like a much better model for Wall Street, and can also serve as a vehicle for substantially increasing transparency and more accurately measuring performance. The way most proprietary trading on Wall Street is done is not with committed, funded capital, but with “notional” capital. The concept is that internal traders get to trade using the bank’s balance sheet and margin lines as collateral, but without a fixed amount of capital assigned to a particular book. How much leverage is a particular book using? No idea. What is the strategy’s true risk profile? Hard to ascertain. What is a portfolio’s actual risk-adjusted return? Since capital is unknown and risk is hard to calculate and attribute, computing returns is virtually impossible. Therefore, it is also hard to fully grasp a traders track record, not in terms of gross dollars but in terms of risk-adjust returns on capital. This is why proprietary trading returns are not able to be presented to institutional investors should a trader or team wish to raise third-party capital. The assumptions that must be made to compute performance are simply too many and subject to manipulation, making investment management attorneys very uncomfortable allowing such figures to be used in marketing materials.
But what if Wall Street moved to a model where books were actually funded (but would still benefit from risk offsets with other books across the firm), returns to capital tracked and auditable track records created? And what if traders were compelled to leave, say, 80% of the increase in their capital account in the fund, ensuring that their wealth is tethered to their performance over many years, not just a single year? This would more firmly align traders with shareholders, much more than owning stock would. Today most proprietary traders get a chunk of their annual compensation in company stock. Honestly, these traders don’t care about company stock, and having lots of it does not make them feel more aligned to shareholders.They apply a huge haircut to this form of compensation. But if their compensation was in cash and reflected as an increase in the accreted value of their capital account, they would be much more likely to protect this than company stock. Traders would also get to benefit from the compounding of their capital balances, providing a huge carrot relative to the current economic model on Wall Street. Finally, since the performance is happening in a transparent fund structure with true capital, the track record can be used should the trader and the bank wish to spin them out as a separate hedge fund.
Structurally, trading businesses on Wall Street are designed as they are for capital and regulatory reasons. Banks get favorable capital treatment for trading books by running them as transparent (and able to be converted to cash in short order), value-at-risk based businesses. Fund structures – when applied to external funds – generally attract less favorable capital treatment because of the inability to compel a manager to reduce risk and because of less-than-perfect transparency. This wouldn’t be the case here, since the fund structures would merely be a structural vehicle for delivering the benefits noted above but with the bank retaining the control necessary to secure favorable capital treatment.
Bottom line, the current Wall Street trader compensation system stinks. It is terrible for shareholders. It is bad for long-term equity building. And it isn’t that great for traders. Moving to a funded-book structure with long-term trader investment scheme would eliminate most of the bad aspects of the current model while bringing in some new, positive impacts. A radical change? Yes. A rational change? Absolutely.