This post, originally published on April 27, was updated on May 18.
This past February, I retired from finance. Although I intend to continue to study the markets and write about them, I have no intention of ever working in the securities industry again. This makes it easy for me to talk to you about what I think is going on and what needs to be done.
I worked at Merrill Lynch as a computer consultant in the mid-1980s, and from 1986 through 1992 I was an employee—first doing research and later creating and running trading desks in New York and Japan. After a brief stint at Credit Suisse First Boston in Tokyo, I returned to the US in 1993 to work as a consultant to a couple of large Wall Street firms. In 1995, I built and ran a statistical arbitrage trading desk for the US branch of a medium-sized Canadian securities firm.
This February, at the age of 61, I retired from that job of 18 years. I can honestly say my time at that Canadian firm was the best of my entire working career and unlike anything I experienced at any other Wall Street firm. At first I could not put my finger on the difference, but at a Christmas party an elderly co-worker from South America I’ll call Eduardo told me he’d been wondering about the same thing. “I have figured it out,” he said, “The word is ‘decent’ and my theory is that in Canada they raise their children to believe that it is more important to be decent than to be rich.”
Although I’m US born-and-bred, both of our sons went to college at McGill in Montreal. That gave me an opportunity to meet plenty of Canadian young people, and if I suggest Eduardo’s theory to their parents, a typical response would be, “Of course I want my children to be decent; who wouldn’t?”
Real engineers understand ethics in a way financial engineers do not
Andrew Lo was the keynote speaker at the 2010 annual meeting of the International Association of Financial Engineers. Lo heads the Laboratory for Financial Engineering at MIT and his talk was titled: “WARNING: Physics Envy May Be Hazardous to Your Wealth!” He explained that a mistaken belief that financial markets can be treated the way physicists treat the natural world leads economists and financial engineers to a false sense of precision that can have disastrous consequences. You will find a very watchable version of his talk here, and if you love equations then you will find plenty in his 71-page paper here.
I came ready to ambush Lo, and after his talk I held up a slide rule and said, “Despite the fact that I brought my slide rule and my pocket full of pens, and that I’ve been using math in this industry for three decades, I know I’m not an engineer. And I know people who are engineers–some of my best friends are engineers–and I don’t think there are any engineers in the world of financial engineering.” I said the distinction between us and real engineers is that we don’t take responsibility for our actions and hold ourselves to the same ethical standards. I asked, “How come the other engineers don’t say, ‘What are you doing to our name?’?”
He responded: “Well, I have a lot of sympathy with those types of sentiments. But I want to expound on that. One thing you said really struck me, and I think it’s at the core of good engineering. Engineers are not perfect. Bridges do collapse. Space shuttles do blow up. And nuclear power plants do have meltdowns. But engineers do something accurate. What they do is they study their failures. They figure out what went wrong and they get smarter about it. I think we need to do that too.”
He explained that when an airplane falls out of the sky then the manufacturers, the airlines, and the government agencies (such as the National Transportation Safety Board) come on the scene, collect the black box, sift though the wreckage and, in a year or so, they produce a conclusive report that explains what happened, why it happened, who is responsible, and what can be done to prevent it from happening again.
I agreed with him, and said, “This should be the Association of People Who Aspire to Someday Become Engineers.”
Our conversation continued for a little bit longer, and the professor wrapped up with, “I think that we need to ultimately become more like engineers in the ethics that they apply and the standards that they use.”
Rather than change our ways, we change our name
Perhaps our conversation had an impact, albeit not the one I’d hoped for. In 2013, the International Association of Financial Engineers changed its name to the International Association for Quantitative Finance.
Notice that it is now no longer an association “of” people but rather an organization ”for” something. People need to take responsibility for their actions and therefore an association of people must weigh all the evidence for and against everything that we want to do. But an association that is “for” quantitative finance can say it is someone else’s job to make the case against it.
Board chairman Richard Lindsey is quoted in the organization’s press release announcing the new name, “This change recognizes that quantitative techniques, thinking, and analysis now reach far beyond the traditional derivatives applications.” OK, fair enough, but I wonder if, as the group reaches for even more areas in which to apply and misapply quantitative techniques, the name change was to make sure we are not confused with real engineers who hold themselves to high ethical standards.
Can we bring ourselves to ask, “What’s wrong with us?”
In 2011, I was invited to join a panel discussion with the title “Beware the Rogue Algo or The Next Flash Crash” at something called The Buy-Side Trading Summit. The description in the program read, “Can a random trade from an algorithm cause another flash crash? How safe are the algos? Our panel has the answers.”
Interestingly, when the panelists were announced I was the only one.
They also asked me to suggest another topic, and I proffered “What’s wrong with us?” This attracted two other panelists to discuss what problems might our industry hold ourselves accountable for. One viewpoint was: What’s wrong with us is that we didn’t insist that the regulators do their job and keep us from doing bad things. Another viewpoint (mine) was: That’s “them” not “us.” Regulators exist to make sure other people don’t do the wrong thing; they aren’t there to make sure we do the right thing—that’s our job.
Afterward an audience member angrily confronted me, “You are absolutely wrong.” When I asked him to tell me how, he said, “I don’t know where to begin.” I said, “Begin anywhere you like.” He stormed off and I didn’t see him again. So I guess it’s up to you to tell me if I’m wrong, and in what way.
What happens when profitability trumps everything else
At Merrill in the 1980’s I worked with a trader I’ll call Jack. Although I’d left after a few years, he stayed on and rose to a fairly senior position. I took him to lunch in 2009 right after Bank of America took over Merrill and he lost his job.
I asked Jack, “When was the last time Merrill could have changed course and avoided bankruptcy?” He described some transactions from 2006 that could not be unwound and that eventually proved fatal.
I asked the same question of Eduardo, my co-worker at the Canadian firm. He said, “I don’t know exactly when it happened, but it was sometime between the 1982 and 1990.” He explained that earlier in his career he’d done two stints at Merrill. Through his last day in 1982 they drummed their policy into everyone: Before we will consider doing anything, ask yourself: is it moral, is it ethical, and is it legal? Then is it in the customer’s best interests? Only if it is all those things, ask if it is profitable because – after all – we are not running a charity.
“But,” Eduardo continued, “when I returned to Merrill in the 1990 that attitude was nowhere to be found.” The question was, “Is it profitable?” and if it is, then is it legal in some jurisdiction somewhere on the planet? Or can we find a loophole? Or can we get the laws changed? Morality and ethics seemed to play no role. He said, “Once you head down that path there is no turning back.” Eduardo is very happy he is no longer at Merrill. So am I. I don’t know about Jack.
We need a solemn ritual
When I first became a trader in 1988, I took a course to prepare me for the Series-7 exam. The instructor was superb. Although he treated the material with a light touch that made it a pleasure to learn, he took the responsibilities of being a registered securities representative very seriously. We knew that if we failed the exam he would be disheartened, but if we failed to live up to our responsibilities then he would be ashamed of us. But since then, nearly every other person I’ve met in my industry views the registration exams somewhere between an annoyance and a joke.
The securities industry needs its own solemn ritual of obligation, such as the Calling of the Engineer that was created by Rudyard Kipling in 1922 for the University of Toronto and now used throughout Canada. Rituals are commonplace and they used to mark an acceptance into a community, an assumption of an obligation, or a rite of passage. Rituals convert the mundane and the trivial into the solemn and the sacred. Marriage, graduation, an military induction ceremonies give emotional import that mere rules and regulations never can. Until we come up with our own, perhaps we can adapt Kipling’s Calling of the Engineer for our industry. Game designers have done that, and you can read about it here.
A high speed trader with integrity (of sorts)
In August of 2012, I had lunch with a very smart high speed trader with 15 years of experience. He was pitching me on his latest technology.
I suggested that rather than find increasingly arcane algorithms for exploiting anomalies in our bizarrely complex electronic markets, why not design a structure for a market that will be robust against gaming and manipulation by people like him. Then he could pitch that to the SEC.
He said: ”The reason I have not had kids is because I don’t want to worry about what they might think of me if they knew what I do, and also I don’t want to think about what kind of world I leave them.” He was very serious. Disagreement on this point had cost him two marriages.
He had an integrity I found refreshing when compared to those who don’t even think about it. Of course, I wouldn’t trade his career for my children, and you shouldn’t either.