by John Coates
Interoceptive information is collected by a forest of nerves that flow back from every tissue in the body to the brain, travelling along nerves that feed into the spinal cord or along a superhighway of a nerve, called the vagus nerve, that travels up from the abdomen to the brain, collecting information from the gut, pancreas, heart and lungs. All this information is then channelled through various integration sites – regions of the brain that collect disparate individual sensations and assemble them into a unified experience – ending up in a region of the cortex called the insula, where something like an image of the overall state of the body is formed. Craig has looked at the nerves connecting body and brain in various animals, and has concluded that the pathways leading to the insula are present only in primates, and further that an awareness of the overall state of our body may be found uniquely in humans.
Lastly and most controversially, Craig, along with other scientists such as Antonio Damasio and Antoine Bechara, has suggested that gut feelings and emotions, rationality and even self-consciousness itself, should be seen as more advanced tools that emerged over the course of evolution to help us regulate our body.
As evolution progressed, body and brain entwined in an ever more intimate embrace. The brain sent out fibres to touch every tissue in the body, asserting control over heart, lungs, gut, arteries and glands, cooling us when hot, warming us when cold; and the body in turn pumped message after message back into the brain, telling of its wants and needs, and making suggestions as to how the brain should behave. In this manner, feedback between body and brain became more complex and extensive, not less so. We did not grow a larger brain just to fit it inside a withering body of the kind seen in sci-fi movies. The brain grew in order to control a more sophisticated body – a body that can handle a sword like Alexander, play the piano like Glenn Gould, control a tennis racket like John McEnroe, or perform open-brain surgery like Wilder Penfield.
Through the research surveyed here, from anatomy, physiology and neuroscience, we have today come to see the body as an éminence grise, standing behind the brain, effectively applying pressure at just the right point, at just the right time, to help us prepare for movement. Scientists, by small steps, are thus patiently stitching closed an ancient wound opened up between mind and body. By doing so they have helped us understand how body and brain cooperate at crucial moments in our lives, like the taking of risks, including, most certainly, financial risks.
PART II
Gut Thinking
THREE
The Speed of Thought
A WAKE-UP CALL ON THE TREASURY DESK
The trading floor we will be observing belongs to a large Wall Street investment bank, located a short walk from the Stock Exchange and the Federal Reserve. We begin our visit early on a crisp morning in March. It is just past 7 a.m., darkness still shrouds the city, street lamps burn, but already bankers trickle from subway stations at Broadway, Broad Street and Bowling Green, or step from taxis and limos in front of our bank. Women in Anne Taylor and sneakers grip coffees; men in Brooks Brothers look freshly scrubbed and combed, their eyes fixed, like an athlete’s, on the day ahead.
Up on the 31st floor the elevator doors open and bankers are drawn into a yawning trading room. Almost a thousand desks line its grid-work of aisles, each one cluttered with half a dozen computer screens that will soon monitor market prices, live news feeds and risk positions. Most screens are black now, but one by one they are switched on, and the floor begins to blink with neon green, orange and red. A rising hubbub absorbs individual voices. Out the front window, across the narrow street, looms another glass office tower, so close you can almost read the newspaper lying on a desk. Out the side window, lower down, climbs a listed 1920s building, its stepped-back rooftop an Art Deco masterpiece: pillars topped with hooded figures; friezes depicting sunbursts, winged creatures and mysterious symbols the meaning of which have long since been forgotten. During idle moments bankers gaze down on this lost civilisation and feel a momentary nostalgia for that more glamorous time, memories of the Jazz Age being just some of the ghosts haunting this storied street.
Settling in for the day, traders begin to call London and ask what has happened overnight. Once they have picked up the thread of the market they one by one take control of the trading books, transferring the risk to New York, where it will be monitored and traded until Tokyo comes in that evening. These traders work in three separate departments – bonds (the department is often called fixed income), currencies, and commodities, while downstairs a similar-sized trading floor houses the equity department. Each department in turn is split between traders and salespeople, the salespeople of a bank being responsible for convincing their clients – pension funds, insurance companies, mutual funds, in short, the institutions managing the savings of the world – to invest their money or execute their trades with the bank’s traders. Should one of these clients decide to do so, the salesperson takes an order from them to buy or sell a security, say a Treasury bond or a block of currencies, say dollar–yen, and the order is executed by the trader in charge of making markets in this instrument.
One of these clients, DuPont Pension Fund, livens up what is turning out to be an uneventful day by calling in the only big trade of the morning. DuPont has accumulated $750 million-worth of pension contributions from its employees, and needs to invest the funds. It chooses to do so in US Treasury bonds maturing in ten years, the interest payments from which will finance retiring employees’ pension benefits. It is still early in the day, only 9.30, and most markets are sleepy with inactivity, but the fund manager wants to execute this trade before the afternoon. That is when the Fed will announce its decision to raise or lower interest rates. Even though the financial community widely expects it to do nothing, the fund manager does not want to take unnecessary risks. Besides, for months now she has worried about what she considers an unsustainable bull market in stocks, and the very real possibility of a crash.
The fund manager scans her telephone keyboard for the four or five banks she prefers to deal with for Treasury bonds. Morgan Stanley sent her an insightful piece of research yesterday – maybe she should give them a shot. Goldman can be aggressive on price. Deutsche Bank entertains well, and last summer the salespeople covering her out of Europe took her to Henley Regatta. After a moment’s indecision she passes on these banks, and decides instead to give her pal Esmee a shot. Hitting the direct line, she says, without the usual chitchat, ‘Esmee, offer $750 million ten-year Treasuries, on the hop.’
Esmee, the salesperson, covers the speaker of her phone and yells to the trader on the Treasury desk, ‘Martin, offer 750 tens, DuPont!’
The trader shoots back, ‘Is this in competition?’ meaning is DuPont getting prices from a number of other banks. The advantage of doing a trade in competition is that DuPont ensures it gets an aggressive price; the disadvantage is that several banks would know there is a big buyer, and this may cause prices to spike before the fund gets its bonds. However, the Treasury market is now so competitive that price transparency is no longer an issue, so on balance it is probably in DuPont’s interest to keep this trade quiet. Esmee relays to Martin that the trade is ‘out of comp’, but adds, ‘Print this trade, big boy. It’s DuPont.’
Looking at his broker screens, Martin sees ten-year Treasuries quoted at 100.24–100.25, meaning that one bank, trying to buy them, is bidding a price of 100.24, while another, trying to sell, is offering them at 100.25. Traders post their prices on broker screens to avoid the tedious process of calling round all the other banks to find out which ones need to trade (in that regard a securities broker is no different from a real estate agent), and also to maintain anonymity. The offer price posted right now on this broker screen is good for about $100 million only. If Martin offers $750 million to DuPont at the offered price of 100.25, he has no guarantee of buying the other $650 million at the price he sold them.
To decide on the right price, Martin must rely on his feel for the market – how de
ep it is, in other words how much he can buy without moving prices, and whether the market is going up or down. If the market feels strong and the offers are thinning out, he may need to offer the bonds higher than indicated on the screen, at say 100.26 or 100.27. If on the other hand the market feels weak, he may offer right at the offer side price of 100.25 and wait for the market to go down. Whatever his decision, it will involve taking a substantial risk. Nonetheless, all morning Martin has been unconsciously mapping the trading patterns on the screens – the highs and lows, the size traded, the speed of movement – and comparing them to ones stored in his memory. He now mentally scrolls through possible scenarios and the options open to him. With each one comes a minute and rapid shift in his body, maybe a slight tightening of his muscles, a shiver of dread, an almost imperceptible shot of excitement, until one option just feels right. Martin has a hunch, and with growing conviction believes the market will weaken.
‘Offer at 100.25.’
Esmee relays the information to DuPont, and immediately shouts back to Martin, ‘Done! Thanks, Martin; you’re the man.’
Martin doesn’t notice the stock compliment, just the ‘done’ part. He now finds himself in a risky position. He has sold $750 million-worth of bonds he does not own – selling a security you do not own is called ‘shorting’ – and needs to buy them. The market today may not seem much of a threat, languishing as it is, but this very lack of liquidity poses its own dangers: if the market is not trading actively, then a big trade can have a disproportionate effect on prices, and if he is not stealthy Martin could drive the market up. Besides, news by its very nature is unpredictable, so Martin cannot allow himself to be lulled into a sense of security. The ten-year Treasury bond, which is considered a safe haven in times of financial or political crisis, can increase in price by up to 3 per cent in a day, and if that happened now Martin would lose over $22 million.
He immediately broadcasts over the ‘squawk box’ – an intercom system linking all the bank’s offices around the world – that he is looking to buy ten-years at 100.24. After a few minutes a night salesman from Hong Kong comes back and says the Bank of China will sell him $150 million at 100.24. Salespeople from around the US and Canada come back with other sales, all different sizes, eventually amounting to $175 million. Martin is tempted to take the little profit he has already made and buy the rest of the bonds he needs, but now his hunch starts to pay off; the market is weakening, and more and more clients want to sell. The market starts to inch down: 100.23–24, 100.22–23, then 100.21–22. At this point he puts in the broker screen a bid of 100.215, a seemingly high bid considering the downward drift of the market. He immediately gets hit, buying $50 million from the first seller, then building up the ticket to $225 million as other sellers come in. Traders at other banks, seeing the size of the trade on the broker screen, realise there has been a large buyer and now reverse course, trying to buy bonds in front of Martin. Prices start to climb, and Martin scrambles to lift offers while he still has a profit, at higher and higher prices, first 100.23, then .24, finally buying the last of the bonds he needs at 100.26, slightly higher than where he sold them. But it is of no concern. He has bought back the bonds he shorted at 100.25 at an average price just under 100.23.
Martin has covered his bonds within 45 minutes, and made a tidy profit of $500,000. Esmee receives $250,000 in sales credit (her sales credit, a number that determines her year-end bonus, should represent that part of a trade’s profit which can be attributed to the relationship she has built with her client. You can imagine the frequent arguments between sales and trading. Like cats and dogs). The sales manager comes over and thanks Martin for helping build a better relationship with an important client. The client is happy to have bought bonds at lower levels than the current market price of 100.26. Everyone is happy. A few more days like today, and everyone can start hinting to management, even this early in the year, their high expectations come bonus time. Martin strolls to the coffee room feeling invincible, with whispered comments trailing behind him: ‘That guy’s got balls, selling $750 million tens right on the offer side.’
This scenario describes what happens on a trading floor when things go right. And in general things do not go badly wrong on a Treasury trading desk. There are certainly bad days, even months; but the really fatal events, like a financial crisis, strike at other desks. The reason is that Treasury bonds are considered to be less risky than other assets, such as stocks, corporate bonds or mortgage-backed securities. So when the financial markets are racked by one of their periodic crises, clients rush to sell these risky assets and to buy Treasuries. Trading volume in Treasuries balloons, the bid–offer spread widens, and volatility spikes. In periods like that Martin may price billion-dollar deals several times a day, and instead of making one or two cents, he may make half a point – $5 million at a crack. A Treasury desk usually makes so much money during a crisis it helps buffer the losses made on other trading desks, ones more exposed to credit risk.
There is a further reason the Treasury desk holds a privileged position on a trading floor, and that is the unrivalled liquidity of Treasury bonds. A bond is said to be liquid if a client can buy and sell large blocks of it without paying a lot in bid–offer spread and broker commissions. In normal conditions, clients can buy a ten-year Treasury at the offer side price of, say, 100.25, and sell it immediately, should they need to, a mere one cent lower. By way of comparison, corporate bonds, ones issued by companies, commonly trade with a bid–offer spread of 10–25 cents, with some trading as wide as $1 or $2. The Treasury market is the most liquid of all bond markets, and is thus perfectly tailored for large flows and fast execution, Treasury bonds being the thoroughbreds of trading instruments.
Such a market calls forth traders with a complementary set of skills. Traders like Martin must price client trades quickly, and cover their positions nimbly, before the market moves against them. This is especially true when the markets pick up speed, for then Martin has no time to think; if he is to avoid owning bonds in a falling market or being caught short in a rising one, he must price and execute his trades with split-second timing. In this his behaviour resembles not so much that of rational economic man, weighing utilities and calculating probabilities, but a tennis player at net.
We are now going to look at Martin’s trade much as an athlete’s coach would, as a physical performance. We saw in the last chapter that our brain evolved to coordinate physical movements, and these, by the very nature of the world we lived in, had to be fast. If our actions had to be fast, so too did our thinking. As a result we came to rely on what are called pre-attentive processing, automatic motor responses and gut feelings. These processes travel a lot faster than conscious rationality, and help us coordinate thought and movement when time is short. We will look at some extraordinary research that demonstrates just how unaware we can be of what is really going on in our brains when we make decisions and take risks.
In this chapter we stray from the trading floor and visit other worlds where speed of reactions is crucial for survival, as it is in the wild and in war, and crucial for success, as it is in sports and trading. In the next chapter we look at gut feelings. These chapters provide the science we need, the background story, that will help us understand what we are seeing when, in later chapters, we head back onto the trading floor and watch Martin and his colleagues as they are swept up in a fast-moving market.
THE ENIGMA OF FAST REACTIONS
We evolved in a world where dangerous objects frequently hurtled at us at high speeds. A lion sprinting at 50 miles an hour from a hundred feet away will sink its teeth into our necks in just over one second, giving us very little time to run, climb a tree, string a bow, or even think about what to do. A spear launched in battle at 65 miles an hour from 30 feet away will pierce our chest in a little over 300 milliseconds (thousandths of a second), about a third of a second. As predator and projectile zero in, and our time to escape runs out, the speed of the reactions needed to
survive shortens into a timeframe our conscious mind has difficulty imagining. Over millennia of prehistory, the difference between someone who lived and someone who died often came down to a few thousandths of a second in reaction time. Evolution, like qualifying heats at the Olympics, took place against the sustained ticking of a stopwatch.
Things are not that different today, in sport, for example, or war, or indeed in the financial markets. In sport we have sharpened the rules and honed the equipment to such an extent that once again, as in the jungle, we have pushed up against our biological speed limits. A baseball pitched at 90 miles an hour covers the 60 feet to home plate in about 450 milliseconds; a tennis ball served at 140 miles an hour will catch the service line in under 400 milliseconds; a penalty shot in football will cover the short 36 feet to the goal in about 290 milliseconds; and an ice hockey puck shot halfway in from the blue line will impact the goalie’s mask in less than 200 milliseconds. In each of these cases, the less than half a second travel time of the projectile gives the receiving athlete about half that time to make a decision whether or not to swing the bat, or return the serve, or jump to the left or right, or reach for the puck, for the remaining time must be spent initiating the muscle or motor response.
Even these short timeframes do not capture the truly miraculous speeds frequently demanded of the human body. In table tennis, which many of us consider a leisurely pursuit, the ball when smashed travels at 70 miles an hour, yet the distance between players may be only 14 to 16 feet, giving the returning player about 160 milliseconds to react. The difference between winning and losing has been shaved to a few thousandths of a second in reaction times. Similar reaction times are found in sprinters, who are so fast off the blocks, reacting to the starting gun in a little over 120 milliseconds, with some even approaching the 100-millisecond mark, that races increasingly feature what are called silent guns. These starting pistols produce a bang which is heard from electronic speakers placed behind each runner so that they all hear the starting signal at the same time. Without these speakers the runners in the outside lanes would hear the pistol with a fatal 30-millisecond delay, that being about the time it takes the sound of the shot to reach them.