Barometer of Fear

by Alexis; Stenfors

  Throughout my career in trading, I was proud of belonging to the LIBOR derivatives community, but even more so to the FX community. At the same time, traders or sales people in FX had to learn to live with certain stereotypical perceptions. For instance, FX traders tended to be noisier than others in the dealing room, and usually cared less about what others thought about them. Because of the extremely fast market, FX traders often had shorter attention spans – they tolerated less bullshit. In addition, FX traders were more street-smart (less educated, others would say) and, supposedly, lived by different rules.

  It should come as no surprise then that the most hilarious (or shocking) stories of traders misbehaving related to FX traders rather than to LIBOR derivatives traders, let alone strategists, analysts, stockbrokers or others in the dealing room. For instance, I recall an FX options trader being dismissed after urinating on an important client; he had probably lost money on a trade and thought that the client had behaved unprofessionally. Although the FX desks tolerated quite a lot of irrational and sometimes indefensible behaviour, this clearly crossed a line. Reputation was important. However, most ‘incidents’ tended to be hushed up without repercussions, as long as the trader made money for the bank. After all, it was quite common for senior managers to have a trading background, which meant they often felt sympathetic towards how difficult life could be as a trader. FX was not for the faint-hearted and it was deemed natural that traders should be allowed to let off some steam every now and then. During my 15 years in trading I was called into the HR department only once to discuss anything remotely related to improper conduct. An FX spot trader had lost his temper, with a senior interest rate options trader the target of his fury. As I happened to be seated back-to-back with the options trader and facing the FX trader, I became a key witness to the physical fight that ensued between the two. I had not seen anything like it since I was 11 years old. Behind the closed doors of the HR department, I tried to convey an unbiased view of what I had seen, expecting that, as usual, everything would be settled with a man hug or a firm handshake. However, when I came into work one morning soon after, the interest rate options trader was gone. I was told that he had left to take up a new opportunity. The incident and the background to it had already been erased from history, leaving behind many more questions than answers. But it added to the trading room folklore.

  However, it was not the extracurricular activities of certain traders that made me doubt that LIBOR was going to be a one-off scandal. It was activities within the working culture itself. Six months after the first batch of FX fines, Bank of America, Barclays, Citigroup, JPMorgan Chase, RBS and UBS were fined $5.6 billion for engaging in collusive practices in the same markets. According to the FBI, the activity involved criminality ‘on a massive scale’.3 Very few have since stepped forward to try to defend the behaviour leading up to the fines, which, when revealed to a wider public not familiar with FX trading ‘activities’, gave banks and traders even more of a headache.

  To understand what went wrong, and perhaps in order to improve how trading and banking are conducted in future, we need to look closer at the rules and conventions that allowed these activities to happen. Before doing so, however, it is important to keep in mind that up until the LIBOR scandal broke two years earlier, the global FX market was still widely perceived to be completely free from manipulation or collusive practices. This is not surprising. Whereas LIBOR was a benchmark and not a market per se, the FX market was (and still is) by far the largest market on the planet. It is difficult, perhaps even unthinkable, to imagine being able to manipulate traded currencies in a market with a daily turnover of $5.1 trillion,4 either single-handedly or in collaboration with a few other traders. The global equity market is huge when all the stock exchanges in the world are put together. The turnover in the FX market, however, is more than ten times larger still. The FX market also appears to be way too competitive for such things to happen. From the moment Wellington wakes up on Monday morning until San Francisco switches off the lights on Friday night, traders quote and deal on immensely tight bid–offer spreads. Even during times of extreme uncertainty and crisis, when some stock markets are forced to temporarily shut down, the FX market continues to work. The FX market simply seems too large, too competitive, too efficient – too ‘perfect’ even – to possibly be rigged.

  But, as with LIBOR, perceptions can be deceptive. Despite being astonishingly large, the global FX market is concentrated within a relatively small group of very large banks. Roughly half of the market belongs to Citi, Deutsche Bank, Barclays and UBS. Add a few more key players, such as HSBC, JPMorgan Chase, Bank of America Merrill Lynch, Credit Suisse, BNP, Morgan Stanley and Goldman Sachs, and this number surpasses 80 per cent.5 The banks are few, but they are also very large. Deutsche Bank has around 100,000 employees, Citi and JPMorgan Chase more than twice as many each. The FX market is not only getting larger but also more concentrated. In Japan, for instance, 19 banks represented 75 per cent of turnover in 1988. In 2010, just eight banks accounted for the same proportion.6 In sum: the pie has become bigger, while being sliced into fewer and fewer pieces.

  Furthermore, the number of FX traders is surprisingly small. You could comfortably fit 80 per cent of the market in any currency pair into a sizeable hotel conference room. Even though I never worked on an FX spot desk, to which the FBI comment related, I still knew or had heard of around half of the traders mentioned in the transcripts. It’s a small world. Three-quarters of those working in the FX swap market for US dollars against, say, Norwegian krone could feasibly do lunch together. It is a tiny market. But everything is relative, and what does it mean if a market with a daily turnover of $43 billion is considered tiny by those in the industry? Until relatively recently, you could literally fit the whole FX market into your pocket. Hambros Bank (a British bank later bought by the French bank Société Générale) used to publish a book listing almost every bank, every dealing room and the Reuters Dealing 2000-2 code for every trader and sales person in the global FX and money markets. Before the internet, ‘Hambros’, as the little red book was called, was indispensable.

  The major FX trading banks operate in many countries and in diverse cultures. The FX market, after all, is by definition an international activity. One might think that this automatically means that there are as many FX cultures as there are countries or languages. On the contrary, the language, customs and norms of the FX market are highly standardised. Even though every global financial centre has its own linguistic features, the lingua franca in the FX market is a curious mix of English, Cockney (a working-class London dialect) and electronic abbreviations – peppered with rhyme, history and a great deal of humour. ‘Cable’ and ‘Loonie’, the standard terms for the currency pairs of US dollars against British pounds and Canadian dollars respectively, are derived from the old Atlantic communication cable between Britain and the US and the bird depicted on the Canadian one-dollar coin. ‘Spaniard’ (referring to the number one, which sounds like the Spanish name Juan), ‘Bully’ (50 points on a dartboard and hence number 50) or ‘Yard’ (rhyming with the French word milliard, i.e. 1 billion) are other examples. Abbreviations (similar to text message shortcuts) such as BIFN (‘Bye for now’) and CUL (‘See you later’) have been around for ages in order to save precious seconds in hectic markets, and add to a trading lingo that is inclusive for those who speak it but is incomprehensible to those who don’t. A foreign trader who might struggle with dinner party conversation in London can often ‘click’ within seconds with a hitherto unknown trader at a different bank in another country. Regardless of whether deals or conversations take place on the phone, via Bloomberg, on Reuters Dealing or through interdealer brokers across the world, misunderstandings are rare. Planet FX might be gigantic, but the population density is remarkably low and the inhabitants speak the same language.

  From the outside, the FX market could also be seen as an extremely ‘efficient’ market, where traders behave rationally at all time
s. Following good news, traders immediately try to buy. Following bad news, traders immediately try to sell. The outcome of such an environment is that exchange rates always incorporate all relevant and available information (whether it is good news or bad news) immediately. If traders do not behave rationally, other traders immediately spot this and exploit the opportunity provided by a mispricing in the market. Furthermore, the irrational traders lose more and more money, so they either stop trading or are sacked. The market is left with the rational, emotionless traders who ensure that the FX market remains hyper-efficient.

  This is the logic of the so-called efficient market hypothesis, developed by professor and Nobel laureate Eugene Fama. For decades, it has been part of the core curriculum at business schools and in economics faculties around the world. It is one of the theories in finance that truly has had a major impact – from students learning the basics of how financial markets work to policy makers and regulators assessing how markets can be made more efficient. Efficiency is, of course, seen as a good thing, as the opposite implies waste. From the outside, the FX market certainly looks efficient, a place where there should be little room for emotion – or, indeed, a special ‘culture’.

  However, in my experience, the FX market is far from hyper-efficient. Traders are not more rational than other people, and many are positively irrational.

  From the Citibank Tokyo dealing room, we could see Mount Fuji when the weather was good. The image of the snow-capped mountain, the line of trees and the water has been reproduced on postcards endless times, and also features on the back of the ¥1,000 banknote. A trader I worked with claimed that whenever he was able to see the famous scene from his desk, he traded well and made money. When he could not, the opposite happened.

  ‘Nowadays, I force myself not to trade when I cannot see Mount Fuji,’ he told me.

  I remember being perplexed by his explanation. Although I understood how important religious and cultural rituals were (even to traders), I had never come across someone admitting to something so irrelevant being of relevance to their trading strategy.

  Professors in behavioural finance have long argued that the efficient market hypothesis makes unrealistic assumptions about human behaviour. In short, they argue that there is no room to account for psychology in the most influential theory on how traders should behave. In the real world, people are not always rational. Moreover, people tend to be irrational over and over again, and in similar ways. For instance, people often exaggerate how predictable things are. Sports betting companies know this all too well. Millions of people think they can predict the outcome of a particular football, hockey or baseball game, yet the bookmaker is always the long-term winner. Sometimes, people see patterns or are able to find predictability even when it is highly unlikely that they exist. The Tokyo trader happened to be a money-making machine, but I doubt if it had anything to do with the weather.

  People also tend to be overconfident in their ability to estimate things precisely, and their level of overconfidence tends to increase in line with the difficulty of the problem in hand. Imagine having to guess whether the next person appearing around the street corner is a man or a woman; there are around 101 females to every 100 males in the world, which makes it a slightly uneven bet. The likely distribution might differ depending on the location and the time of day. However, unless you had thoroughly researched the area, guessing the right answer would be like flipping a coin. When I did my internship at Dresdner Bank, I was sent to a training camp in the German countryside to learn about FX and interest rate derivatives. This time around, the traders and sales people were much more senior and no plans to break into a bar were discussed. The boredom and frustration grew steadily, though, and after a few days the PIBOR futures trader decided that he had had enough and made his escape in his Porsche. I declined his kind offer of a lift back to Frankfurt. Not only was I working in the back office, I was a temporary member of staff and actually found the intensive course very interesting. On the nights not spent in my room, listening to Sonic Youth or Theatre of Hate on my Walkman, I tried to hang out with the traders and listen to their stories. One FX spot trader told me how they used to play the male/female guessing game when he used work in the New York office. The standard wager was $1,000. The game was not like roulette, which, of course, is completely random. Instead, it was almost random, which made it incredibly difficult to play with any degree of success. However, the game seemed to appeal to certain traders, particularly overconfident male traders like him. I cannot remember whether he had been a skilful player at this game, but given that he happily ordered and paid for round after round of drinks, I have a feeling that he must at least have felt like a winner.

  In fact, overconfidence appears to be more common among men than women,7 and also in professions where blame can easily be shifted to others if things go wrong. Given the limitless number of unforeseen circumstances in the financial markets, this shifting of blame comes almost instinctively to traders in the male-dominated dealing rooms. Blame is constantly apportioned to central banks, politicians, competitors, brokers, customers, sales people, back office staff, risk managers or interns. It is much more convenient to interpret information in a way that is beneficial to yourself, even when trying to be objective and unbiased. If you have bought a new car, information that contradicts how smart your purchase was is uncomfortable. Reading a car magazine praising your chosen model, on the other hand, feels great. The same applies to trading. If the market goes your way, it is like music to your ears. If the market goes against you, however, it is tempting to pick up the phone to someone who you know is on the same sinking ship so you can convince each other that you are right and the market is wrong.

  I remember being reminded of this in the late 1990s, after gradually having increased my position in a specific type of interest rate swap. Confident that I was doing the right thing, and that everybody else in the market was blind to the magnificent trading idea I had formed in my mind, I kept on adding to my position. The fact that market prices then moved in my favour convinced me that I was right, and gave me further justification for adding a bit more to what was already a very large bet. One day, when the market suddenly stopped going my way, one of my managers came over to me. ‘Your position is massive,’ he said, red-faced, almost as if he had been waiting for this moment to arrive. ‘You know which bank is on the other side of your trades. They are professionals. Have you thought about why they keep being on the opposite side?’ I had, perhaps unconsciously, suppressed the thought that I was betting against very experienced traders who knew what they were doing. I might have scored a few goals in the first half of the match, but they had begun to detect a fragility in my defence. They could see my overconfidence had taken over, and had started to bet on the fact that the market (and my luck) would turn. I felt like a schoolboy being told by a teacher to stop doing dangerous tricks high up on a climbing frame. It was humiliating, but he was right. I reduced my positions and escaped with some minor scratches. I could recite countless more examples where I have traded irrationally as a result of exuberance, hope, regret or fear – or have witnessed colleagues or competitors doing so.

  ***

  I saw a psychotherapist on a weekly basis from March 2009. Then, after two years, I stopped. I no longer felt a need to explore my inner thoughts by going to the sessions. Instead of sitting in the comfortable armchair and talking non-stop for 60 minutes, I had begun to ask more and more questions about psychology in general. I guess I had begun to learn some of the tools, or knew what the toolbox consisted of, should I ever need psychoanalytic theory again to solve personal problems.

  I knew more about myself than she did. She, however, knew more about psychology, having spent years studying the subject and listening to people in the comfortable armchair.

  Academics and experts in behavioural finance emphasise that investors and traders should be aware of their own – and others’ – psychological biases and take them into account when
trading. This makes perfect sense. The financial markets consist of human beings (or, increasingly, computer algorithms programmed by human beings), and human beings do not always behave rationally. However, even though this contradicts the efficient market hypothesis, proponents of the two different schools have one thing in common. Both tend to assume that traders act as market takers (approaching a market, which somehow already exists) rather than as market makers (creating that market). In other words, traders are seen as patients who either are rational or can learn to become more rational by visiting a therapist. Traders are not, themselves, the therapists.

  Prices such as exchange rates are therefore seen as being generated by the interactions of a large number of day traders, investors, retirement planners and other customers approaching a market place that is somehow ‘already there’. The profession of market makers tends to be ignored. I find this strange, because although few traders I know have received any formal training in psychology, if there is one thing market makers share, it is the ability – even the necessity – to ‘read’ the market. Market makers don’t just sit in the comfortable armchair. They constantly switch roles between asking for prices and quoting prices, between knowing when to buy or sell and knowing when others want to buy from, or sell to, them.

  Therefore, I have generally found that the strongest critics of the efficient market hypothesis are neither behavioural finance academics nor economists critical of conventional finance. Rather, they tend to be market makers quoting prices all day long, all the while not knowing in advance whether the other person is a buyer or a seller. They have spotted the theoretical flaws in a different way: by witnessing others (and themselves) losing money as a result of irrational behaviour. Constantly exposed to the psychology of the market, market makers develop skills that help them recognise predictable psychological flaws in others. Having the ability to read the market, or see behavioural patterns faster and more clearly, has obvious advantages. If you can detect fear, exuberance or hubris in others, you can incorporate it into your own quoting behaviour. Traders know this, and traders also know that other traders sometimes might be better informed about the likely direction of the market. If the other person trades on a two-way price you just quoted and bought from you, your price is quite likely to have been too low. It is unlikely that you would be able to buy it back from someone else without making a loss or hoping that the market would turn the other way. If the other person just sold to you, the price was probably too high. Once, a mortgage bond trader I was sitting close to was so delighted at having quoted a price that was left alone that he leapt up and raised his arms with joy. Having to quote a tight bid–offer price in a large amount to a fierce competitor in a volatile market could be nerve-racking, especially if your gut feeling told you that the other trader knew in what direction the market was heading. It was like trying to save a penalty kick by Cristiano Ronaldo. He must have felt like the best goalkeeper in the world at that moment.