There are times I think I am hopelessly naive.
For three years in the early 1990s, I had a cutting-edge Chicago-based derivatives firm, O’Connor & Associates, as a client. They had 750 employees and no customers, at least initially, which gives you an idea of the scale of their business.
O’Connor did statistical arbitrage, which meant they bought and sold derivatives when the market price was out of whack with the theoretical price. They also took some point of view positions based, for instance, on whether they thought volatility was cheap or dear. They often traded 5% of NYSE volume hedging their equity derivatives book They were big in FX as well, and had a risk arb book.
The firm was a cross between Wall Street and Silicon Valley. Half the firm’s budget went to technology. They ran the largest Unix network in the world and were constantly rolling out new trading algorithms. They were also very early adopters of the chinos and knit shirt dress code.
Why this long-winded intro? Because the view of the derivatives world I got from O’Connor and the one I got second-hand via Frank Partnoy’s Fiasco occupy parallel universes. Yet I would have no doubt that Partnoy’s realm was closer to industry norms than the world I saw (and I had untrammeled access to a firm so security conscious that it was compartmentalized physically, with each section having its own secure entry, and pass cards that opened all doors were the exception rather than the norm).
Due to the increasing efficiency of pricing in derivatives, the returns to its traditional arbitrage strategy were falling. O’Connor decided it needed to start serving customers to capture the additional margin. The firm quickly, along with Bankers’ Trust, became the leaders due to their ability to offer particularly complicated custom solutions (the trick was knowing how to hedge the trade, otherwise you couldn’t price it). O’Connor people often complained about BT because they were grossly overpricing their trades. You would think they would welcome that, since it give an umbrella under which O’Connor could operate. But the pricing was opaque; options typically had no explicit payment, but would involve the customer absorbing certain risks to get the protection they wanted. A simple version is a cap and floor. A customer worried, say, about interest rate increases might get that coverage in return for paying the dealer if rates dropped below a certain level.
The O’Connor crowd thought that BT’s practices would taint the entire product once customers figured out they were being had. Though BT was damaged when various lawsuits against them by aggrieved customer led to damning tapes of recordings of the sales force conversations were made public via discovery, the wider impact O’Connor feared idd not take place. BT was seen as a rogue operation.
Parnoy’s account of his time at First Boston and a longer stint at Morgan Stanley makes the BT revelations look tame. In realty, the seeming difference is probably largely a function of disclosure. But it certainly suggests the view that the public took, that BT was an outlier, was hopelessly naive.
Fiasco describes an environment where predatory behavior was prized and encouraged. Salesmen would describe with glee how they ripped a customer’s face off, or blew them up. Skeet shooting outings similarly and explicitly depicted the exploding clay birds as proxies for customers.
Partnoy also strongly suggests that there were pretty much no legitimate uses for derivatives. He divides customers into two camps: those that were knowingly using products with embedded derivatives to evade regulations, and hapless chumps (and those always got the first call when Morgan Stanley badly needed to place a trade). The skirting-the-rules uses included insurance companies that bought bonds that in fact were foreign exchange plays (bonds are permitted investments, FX speculation is a no-no), and Japanese companies who used derivatives to create phony profits to mask losses they had suffered elsewhere (in grossly simplified terms, the derivatives were sold to the customer, then in part sold back to Morgan Stanley. The sale back showed an enormous profit, which was reported immediately, the part retained has a corresponding very big loss, but that would not be reported till years down the road).
Partnoy is a skilled and often very funny writer, and he sets forth in detail that a layperson can understand how some of the products worked and what the economics to the firm were. But the centerpiece is the lurid, shameless, but prized for its productivity culture.
Aside from the frequent complaints about Bankers Trust (and this was not sour grapes; O’Connor’s market share was at least as high as BTs’ and its skills were probably a notch better, since O’Connor could sometimes place trades that BT could not).I did get some indirect evidence of the standards of the industry, or more accurately, the lack thereof. For instance, at one point, the O’Connor types were panicked that they were losing marker share, since their desk was hearing reports of big trades being done away from them, I was dispatched to investigate, and ascertained that the volume of trades was being exaggerated by a factor of three, perhaps as much as ten, as various firms were laying claim to trades they had not done. I had salesmen to my face assert they had done specific hedges on specific transactions that had been in fact done by O’Connor. There was, however, one market opportunity they had overlooked that was a natural for them, and once alerted, they pursued it to handsome profit.
O’Connor sold itself to Swiss Bank in a two-step transaction because it needed access to a much bigger balance sheet. Unlike most big firm acquisitions of boutiques, SBC managed not to screw it up. SBC gave the O’Connor partners a number of board seats that was considered scandalous in Switzerland, and Marcel Ospel saw the transaction as a vehicle for transforming SBC and thus gave the former O’Connor top brass the variances they needed to be effective.
Unfortunately, as often happens when firms are acquired, the deal meant I was no longer seen as being a suitable advisor. Big firms tend to like to hire brand names, and the sort of projects I once did went to McKinsey. So even though I stayed friendly with my immediate clients, I have no idea how quickly the O’Connor culture moved to the low industry norms. There was an angry, almost offended reaction to the idea of buying Bankers Trust when the scandal-ridden firm was on its last legs (it was purchased by DeutscheBank). I have to believe, given how “talent” moves around in the industry, that SBC, later UBS (SBC was the dominant player in that deal, contrary to the retention of the UBS name) came to be pretty much like everyone else in derivatives-land.
Even though Partnoy’s book is now more than a decade old, I’d assume things have not changed very much. The internal banter may more civil, the predatory imagery less open, but I’d suspect that customers are still viewed as sheep to be sheared. Or worse.