Regulating Traders via Earn-Outs

Provocative post by John Jansen on regulating the markets via tying trader performance more closely to longer-term performance. It’s an idea I’ve been pushing too, but John has articulated it better:

In the current framework a trader’s focus is only on the fiscal year in which his bonus is determined. As each new year begins, individual traders cash their bonus checks and start the year “tabla rasa”. The motivation for a trader is to maximize the current year bonus.

I think that this can lead to perverse risk taking and probably did as the initial subprime mess unraveled. I offer the hypothetical case of a proprietary trader who had been eminently successful for several years in a row and chalked up large bonuses. We are well into a hypothetical 5th year and things are not going so well as the trade sours big time. Rather than unwind the trade and take an acceptable loss, the current system encourages a big risky bet. It encourages doubling down or adding to a bad position because there is no penalty for a big bet gone awry.

So in this instance a trader who has enjoyed considerable success and has banked large bonuses might look at the situation and take inordinate risk because the worst outcome is that he returns home as a full time member of the rentier class and he clips his coupons until he finds his next gig.

I would suggest that each year a portion of a trader’s bonus should be held back and that it should be placed in an escrow account of sorts for five years. Let it earn the interest on the 5 year note.

If however, the trader loses some amount of money above some predefined trigger level, then some of those losses should be paid for from the trader’s prior year bonuses.

I think that this would align traders with shareholders and would reduce sloppy risk and sloppy risk control.

More here.