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 traderâ€™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 â€œtabla rasaâ€. 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 traderâ€™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 traderâ€™s prior year bonuses.
I think that this would align traders with shareholders and would reduce sloppy risk and sloppy risk control.