trader incentive contracts, trend chasing and market manipulation

Robert Waldmann

I understand that traders are compensated roughly half based on mark to market profits in a given year and half on long term outcomes (the was the AIG AIG-FP deal). This implies that many people made a lot of money being wrong about the housing bubble etc. It also implies that the conditions for profitable market manipulation are much broader than they would be if market manipulators were trading their own money and the conditions for sophisticated traders to buy into bubbles are weaker.

Using his BA in philosophy Matt Yglesias gets this point. Compensation based, even in part, on short run mark to market profits is a recipe for disaster.

I see (via Yves Smith) that Financial Times’ John Dizard puts it well

A once-in-10-years-comet- wiping-out-the-dinosaurs disaster is a problem for the investor, not the manager-mammal who collects his compensation annually, in cash, thank you. He has what they call a “résumé put”, not a term you will find in offering memoranda, and nine years of bonuses….

A “model” after the jump.

The model is based on

J. Bradford DeLong, Andrei Shleifer, et al (1990), “Positive-Feedback Investment Strategies and Destabilizing Rational Speculation,” Journal of Finance 45: 2 (June), pp. 374-397.

There are 3 types of agent in the model. First necessarily there are momentum traders or trend chasers, agents who buy assets whose price just increased (say like you know houses). Second there are value investors whose demand for assets is downward sloping in current price just like a normal demand curve (call them Buffets)
super smart investors who know all about fundamental values *and* about the momentum traders (Soroses). There were two results, under extreme assumptions about mementum traders it is possible that sophisticated traders drive asset prices further from their fundamental value when there is a disturbance, that is pump up the bubble. It is also possible that, without any exogenous shock, the sophisticated investors deliberately trigger a bubble — that is manipulate the market.

The asset in the model is finite lived. The challenge is that it gets back to its fundamental model when in matures (in period 4). This makes it hard to find cases where it is rational to buy into a bubble or manipulate the market.

With an incentive contract such that people get paid in uhm period 2 based on marked to market profits then never ever have to give that money back, I think it is enough that there be some momentum traders.

Let’s say I am a manager who controls a large amount of money and I want to manipulate the market. I buy a lot of an asset. I have to pay a high price to get it from the Buffets. Suddenly momentum traders want the asset too so next period they buy (and I don’t sell). Mark to market says I have made money. If other super sophisticated traders know what is going on they will cooperate with me. I think this strategy is technically illegal, but there is no way to detect it.

I think the only thing that protects us from this is the irrational arrogance of financial operators. They consider their position to be very valuable as they think they can systematically beat the market. If they knew they were mostly just lucky to be where they are, they would be more tempted to cash in by manipulating the market.

In any case, the fact that traders don’t really lose when they buy into bubbles is a reason that only the very very top managers got a bad deal out of the 21st century so far.

I think the worse problem is, as Yglesias note, the contrarian looses for a while and might be out of the business irreversibly by the time the crash comes.