12.05.2011

What Makes a Trader Go Rogue?

Rogue trading, or the act of independently making, and often obfuscating, reckless losses in a firm's accounts, has become so common that the uncovering of these situations has lost the shock factor it had in the days of Leeson. This is despite the fact that the dollar figures involved in such scandals have become increasingly mind-blowing.

However, despite the rising frequency with which rogue traders make the headlines in the financial press, the fundamental question of why they have done what they have done often goes asked and unanswered. This is no simple question of greed; traders would usually have very little chance of personal financial gain even if their trades were to go right. And, even if the potential for a big bonus is the lure, it is clear that the downside of jail time and public humiliation far outweighs the upside of pecuniary gains in the minds of most rational observers.

Over the weekend, John Gapper of The Financial Times outlined an interesting theory that might do a better job of explaining rogue behavior than simple financial incentives; biology. In his article What makes a rogue trader, Gapper identifies research suggesting that many species will take bigger chances when they are already in a hole (whether the deficit is made up of seeds or dollars) than they would otherwise. And, since this risky type of behavior often leads to survival in the case of, say, food shortages or droughts, risk genes are more likely to be passed down through the generations. In other words, we might be genetically predisposed to go double or nothing.

Who knew that sparrows and bumblebees could provide such insights into market behavior? If what Gapper suggests it true, it would seem that we are less Homo economicus and more Bombus pennsylvanicus, not necessarily a happy thought for all the neoclassical microecononomics holdouts in the audience...

2 comments:

  1. Anonymous6/12/11 11:03

    I'm reminded of an SEC case brought against an adviser who invested over 80% of his 50-something clients' money in Google options. The first time, he realized a gain of 400%, and there was no SEC investigation. Then he tried to do it again.

    At first, he just lost money. But he kept trying to recreate his big trade, eventually leveraging the client accounts, and ultimately plunging his clients on the verge of retirement into the hole.

    The real problem with "double or nothing" is that when it works, traders perceive their reckless moves as smart, and do it again. Played that way, one never wins the game, but only delays losing.

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  2. Josh Sturtevant6/12/11 21:53

    Excellent point. The situation you describe is not strictly 'rogue trading', but the double down behavior is the same.

    Risky behavior does indeed pay off sometimes, but overly risky behavior inevitably leads to one being in arrears to the piper at some point.

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