THE JUNGLE ROOM.
The trading scandals of the City are well documented but Mary Bogan explores the biological reasons and the ways to change the culture.
He was known as the “London Whale”, the “Caveman”, “Voldemort”. A mega-dollar earner, working for the bank famed for successfully circumnavigating the worst of the 2008 financial crisis, JP Morgan’s Bruno Iksil, was the kind of risk-taking trader whose long track record and bullish style made him widely admired, if a little feared, in the trading community. However, in 2012, Iksil’s career crashed around his ears. In a strategy which, according to the banks’ own chief executive, featured self-inflicted “errors, sloppiness and bad judgement”, Iksil, together with a handful of other key players, lost the bank a cool $6.2 bn, taking the record for the US bank’s biggest trading loss ever and earning a place in the league of greatest trading blunders of all time.
Iksil’s story may be one of hubris writ large but the tale of the prudent trader who, after a long run of success, then crashes and burns is not an uncommon one. Why? Typically it’s to charts, data and strategy that banks turn to find a rationalisation. But, according to a man who once ran trading desks for Deutsche Bank and Goldman Sachs, the explanation for reckless trading and rash decision-making often resides in a more surprising place – the body.
“Risk-taking is not just an intellectual, cognitive activity based on analysis and reason,” says John Coates, a successful Wall Street trader turned Cambridge University neuroscientist. “When you take a risk, you face a threat, a potential hurt. And when humans are under threat, the body responds by preparing for action.”
The physical changes that kick in when traders prime themselves for action – the accelerated breathing, the thumping heart, the tense muscles, the knotted stomach, the sweating brow – are familiar to anyone who trades. What is less obvious though, and what Coates’ workplace research has proven is that, accompanying these visible outward changes, is a series of invisible, hormonal adjustments that can shift traders’ appetite for risk and affect their capacity for rational decision-making.
Central to these internal changes are the male hormone, testosterone, and the stress hormone, cortisol. In experiments conducted on London trading floors, Coates’ team has found that when traders get ready to risk-take – like other young males in the animal kingdom preparing for competition – their testosterone levels surge. But when testosterone rises, the chemical balance of the brain changes. Confidence rises and the appetite for risk increases. If then the risk pays off – if the trader ‘wins’ the bet – testosterone levels surge higher. In what becomes a virtuous winning cycle, the more the trader wins, the more testosterone rises, the more risks the trader takes, the greater the chances of winning again.
What applies in the jungle, applies in the City. In just the same way that when two equally matched lions compete against each other, it is statistically more likely the testosterone-fuelled animal that won before will win again, so it is that the testosterone-fuelled trader who has placed a winning bet before will do so again. This is the physiology behind the familiar image of the trader on a winning streak.
At some point in this upward victory spiral, however, testosterone overshoots and judgement becomes impaired. As a result, effective risk-taking morphs into overconfidence. Prudence gives way to recklessness. The star trader places ever-increasing bets despite ever-worsening risk-reward tradeoffs. Then one day, just like the London Whale, his positions blow up.
At this point, another hormone, cortisol, sends the trader at the losing end of the game on a downward spiralling trajectory. As the body’s stress response goes into overdrive, anxiety rises, danger is perceived where there is none and an irrational risk aversion takes over. The end result is another widely observed phenomenon on trading floors: the trader whose confidence is shot, whose ability to trade, even in clement market conditions, is paralysed.
The human factor
In the hard-bitten financial world, a physiological explanation of traders’ winning and losing streaks, and the irrational exuberance and pessimism they engender, may seem outlandish but, judging by the interest in Coates’ ideas, there is some acceptance that the theory does chime with practice.
“The idea that risk-taking has a biological dimension, that the state of your body might be predicting your performance in markets, may seem odd at first. But traders quickly recognise a truth in what I’m saying. They see it explains why they so often succumb to recklessness at the end of a winning streak and why, when losses mount, they experience extreme stress and fatigue,” says Coates.
The notion that trading has a powerful human dimension clearly has major and wide-ranging implications for banks, starting with risk management, where the introduction of a warmer human touch could help risk managers curb individual traders’ wilder excesses.
“In my view, managing risk is a human activity,” says Marcus Cree, vice president, risk solutions at SunGard. “But right now too much time is spent in back-offices producing numbers and reports. Risk managers need to get out on the floor and engage with the mentalities and personalities of traders. An effective risk manager is the person a head trader can consult in volatile markets and say, ‘OK, things are going crazy here. Who are the people we need to watch?’”
One way risk managers could answer this key question, says Cree, is to collect information on how individual traders react under calm and stressful market conditions. These profiles could then be built into stress testing and risk budgeting, with each individual trader being set an individual risk limit according to their personal trading style.
Re-establishing human connections on the trading floor could also mitigate reckless risk-taking through improved monitoring, according to Paul Hayward, acting managing director of OANDA, EMEA. “When I was trading up until the mid-nineties, before technology took hold, there was a lot of human interaction. You were constantly speaking to other departments, explaining decisions to your bosses or colleagues and people could see what others were doing. It was almost self-policing.”
Reverting to some kind of apprenticeship where junior traders are guided through the idiosyncrasies of different market cycles under the wing of seasoned traders until judged fit to fly solo, may also prepare traders better for risk-taking than the finite six-month rotational schemes common for graduates today.
Changing the composition of the trading floor could also dampen the worst excesses of testosterone-charged recklessness. Attracting more women and retaining older, more experienced male traders to trading teams – which are invariably young and male – could make for more balanced decision-making, while pulling young male traders off the field, before they reach the end of their winning streak, would give an opportunity for testosterone-fuelled bodies to calm down and reset.
A change of pace
Perhaps the biggest changes needed in banks are in management style and culture, recommends Coates. Macho managers, who rule trading floors by fear and create a climate in which mistakes are likely to be driven undercover, need to be discouraged from leadership roles. Rewards policies that incentivise short-term performance and hiring policies which currently resemble a revolving door, need to be to reversed and stabilised. Two institutions which have started to move in this direction are Deutsche Bank and Goldman Sachs. Deutsche, for example, has announced that bonuses for senior bankers will be paid once every five years instead of annually while the decision by Goldman to end two-year contracts and bonuses for new hires in investment banking and investment management is partly designed to emphasise long term career opportunities, says the firm.
Another intervention open to banks is to change the kind of person they recruit into trading. According to Hugo Pound, managing director of leadership consultancy RDI, this is exactly what banks are now doing. But the move has less to do with any wish to lower testosterone levels on the trading floor and more to do with the changing nature of bank trading since the financial crisis.
“First, trading is not seen as an isolated, separate island anymore so banks need people who have the maturity to recognise the complex interdependencies across the business and the ability to build relationships inside and outside the organisation. The second thing is with greater regulation and capital getting scarcer, banks, keen to mitigate risk, want people who will respect compliance and the law. Certainly the anecdotal evidence from the past is traders didn’t do that. Now, trust, honesty and transparency are the qualities being emphasised.”
According to Pound, the kind of thrill-seeking risk-taker who used to be found on almost every trading desk is now migrating to hedge funds where fewer compliance rules and greater freedom are to be found.
So does that make Coates’ research an increasing irrelevance for banks, an idea whose time has passed? Coates doesn’t think so.
“These ideas are applicable to any organisation taking risk not just banks. And judging from the money banks still make, trading won’t be disappearing any time soon. Even black boxes and algorithms don’t remove the human dimension from trading.”
“I just don’t think we can cut our bodies out of the picture and I don’t think we want to. When it comes to decision-making, some of our most valuable signals are our gut instincts.”©BestExecution