Head of derivative structuring: Structurers are like snakes

The Joris Luyendijk banking blog on the Guardian provides a monologue by a former head of derivative structuring.  The monologue touches on several of the issues discussed on this blog.

A rule of thumb in trading that I learnt very early on, says: there is a fool in every trade. You have to know who the fool is, because if you don't, then you are the fool. 

The financial markets are a shark tank, it's in the nature of the beast. Trading is a zero-sum game. Either you win, or you lose. There's no middle ground.... 

"Structuring is a bit like project management, in a way. You need to work out what it is that your client, often a corporation, wants, because they often come to you with rather vague ideas. 

Then you break it down into pieces and work your way down the list of what needs to be done. Figure out which financial instruments they need, work down the legal and tax aspects, and so on.... 

"All the Greek stuff that happened, where investment banks helped the Greek government move many of its debts off balance so their budget would look better – that was typically the job of structuring. 

Here is an example where structuring is not about laying off some type of financial risk, but rather helping the client to deceive other market participants.

"Lots of the derivative business is tax-driven. There is the so-called stamp duty tax of 0.5% on particular financial transactions. Banks and other members of the London Stock Exchange are exempt. You may structure a derivative for a client in such a way that technically it's the bank doing the transaction, saving you the stamp tax.... 

"Generally, I'd say that 80-90% of all derivatives are morally ambiguous, to say the least. It's mostly to do with accounting, legal or tax needs, with greed or fear or with gambling. .... 

"There is value in some of this. Derivatives can help you eliminate certain risks, for example price fluctuations. The textbook example is of farmers who could sell their harvest months in advance for an agreed-upon price with a future. 

"Great example. Except my own grandparents were farmers. They never used futures because they considered them too complicated.

However, interest rate swaps were not considered too complicated for RBS to sell to a 19 year-old.

"So why did I quit? It was like the story of Dr Faustus, where you sell your soul to the devil. I sold my soul for worldly riches. The price the devil demanded was my moral bankruptcy. 

"For a long time I was OK with that, until I wasn't. What triggered this change of heart? There was not one particular moment. You have to look yourself in the mirror every morning. I imagined a future son or daughter ask me, daddy what do you do for a living? What was I going to say? 'Well, sweetie, daddy rips clients off?' ...

"Obviously I read the Greg Smith resignation letter. He raises valid points, but I take issue with the idea that the toxic practices he describes are that different from what went on in the past. The main difference is that it's now much bigger, and even more complex.... 

"The advisory part of investment banking, mergers and acquisitions and corporate finance, are still more like the banking of old. There it's about nurturing relationships with clients over many years, very refined and working on trust. 

The trading floor is more like a poker table. People look at odds instead of trust. Put simply: the advisory part of investment banking is about clients who need money, the financial markets-part about clients who have money. That's the difference.

Investment bankers have clients, traders have counter-parties.

"These days I believe regulators need to become much, much firmer. I have been thinking about joining them, in fact. 

My sense is that regulators have good intentions, but the complexity of the industry makes it very difficult. And there's the lobbying. The Dodd-Frank act in the US is supposed to prevent another Lehman Brothers-type crash. It is over 2,000 pages long by now. 

"This financial crisis has crippled the western world, and the consequences will be with us for another ten years, at least. It is really big, and something like that can happen again. I'm sure that in four or five years, some smart structurer will find a clever way to get around this regulation, and God knows what will happen then. 

"There are always unintended consequences of any new regulation. Do we need all this complexity? I kind of agree with the joke making the rounds among bankers that the last useful financial innovation was the ATM machine – and that was 40 years ago....

Requiring ultra transparency is the simplest regulation that there is.  It is easy for banks to provide on an on-going basis their current asset, liability and off-balance sheet exposure details.

"I am still pro-free market, no mistake about that. Companies need to raise money to invest, innovate, expand. Ordinary people need returns on their savings so at some point they can retire. This should be the raison d'etre for the financial sector. 

But by now the sector has grown so much in size and complexity ... And as a result the opportunities to abuse the system have multiplied by many times. Many times.

Complexity that is not needed to support either companies or ordinary people.

Complexity that is only there so that the banks can make more money and hide how much they are making.

"A term like 'derivatives' puts people off but it's not terribly complicated, once you get beyond the lingo. Equity is roughly the same as shares. Equity derivatives are products that derive their value from them. 

"There are options, when you can buy or sell shares for a particular price at a particular moment. There are futures, when you oblige yourself to buy or sell something for a particular price at a particular moment. My favourite example: When I order pizza delivery, I agree to buy a product for a particular price at a particular time. That's how a future works. There are swaps when you agree to exchange something at some point in the future. 

"A big thing in derivatives is figuring out the value of these contracts. You don't know what the price is going to be of a certain share in three months time. So what is the contract worth that allows or obliges you to buy that share in three months time? There are complicated simulations for determining the value. 

The problem lies with the assumptions underlying those simulations. For instance the assumption there will always be buyers and sellers. In times of crises, that is not the case. 

"Everything we built was bespoke, specifically designed for the client. Now, the trouble was that such a bespoke product would be sold on, and then it would be sitting somewhere in the financial system. But where? 

"This doesn't really matter, until you have a major event like the collapse of Lehman Brothers, and suddenly everybody worries about so-called counterparty risk. Who is holding what financial obligations to whom?... 

Hence the reason that ultra transparency needs to be required on a global basis.

In equity derivatives there are different categories of clients. 

You have got retail customers, ordinary people if you will, who are pretty well protected. 

There is also the class of professional investors or market counterparties and with them it's anything goes, really. The assumption is that professional counterparties should know what they are doing, caveat emptor and all that. 

"Now there are very sophisticated parties out there. But there are also smaller players who basically have no idea what they're doing. Some small Spanish savings bank perhaps or some municipality in Sweden. What got to me after a while is how I'd be lying in the faces of these less sophisticated parties. And I'd be thinking, wow, this is my parents' pension money down the drain.... 

Worth re-reading as lying to less sophisticated parties was okay because these parties had to protect themselves under caveat emptor.

"Structuring people would be like snakes.