Earlier we took a look at how sales and trading get paid. Now we’ll take a closer look at how these incentives can be misaligned.

To recap: Jack the salesperson gets sales credits for getting clients to do more trades with the bank. Jane the trader gets paid to manage the risk from client trades.

When we’re deciding how much to pay Jack the salesperson at the end of the year, we’ll just tally up all the sales credits that Jack has accrued from the his clients’ trades. To pay Jane the trader, we’ll look at the value of her trading book. Hopefully, that value has increased, courtesy of Jane’s good work. Seems simple, right? Jack wants more sales credits and Jane wants positive PNL in her book.

The problem here is that not all risk is made equal. There’s good risk, bad risk, red risk, blue risk, easy to make money risk, and easy to lose money risk. While the salesperson may not care about the kind of risk, the trader cares a lot because that’s how she makes money. Ideally, the trader wants risk that she has a view on, i.e. a belief that the value of the risk will move in certain direction. Disbarring a view, the trader wants risk that will flatten out her position by offsetting against existing risk.

Ideally, Jack’s clients knock on the door with a mixed bag of risk. One client’s risk will offset against another client’s risk, resulting in that sweet, sweet two-way flow. Whatever risk that doesn’t net out, Jane will either risk warehouse or use street liquidity to neutralize. The problem arises when Jack’s clients all have the same flavor of risk. This may happen because of fundamental supply/demand imbalances for certain types of risk – for example, the producer vs consumer imbalance for long dated natural gas. Alternatively, this may also happen because Jack is only friends with clients that give certain types of risk. Jane the trader can’t properly risk manage all this one-sided risk so she ends up: 1) quoting really bad prices, 2) risk warehousing more risk than she is comfortable with, or 3) paying someone on the street to offload this risk.

Jack’s goal is to get his clients to do more business.  Meanwhile, Jane is screaming bloody murder because she can’t properly risk manage it all. Jack is getting pissed because his trader either refuses to trade with his clients or better yet, keeps on quoting his clients laughably unfavorable prices. Jack can’t get paid unless his clients do business with Jane, but Jane can’t get paid if she does business with Jack’s clients. Jane wants Jack to go out and find more clients with good risk. Jack, choosing to optimize for his bonus, gets more bang for his buck by spending time developing his current clients than he does trying to find new clients.

Ideally, Jack would be incentivized to find clients that bring on good risk. Here, we get into the murky waters of compensation. How much is good risk worth relative to bad risk? Is this a symptom of Jane’s risk management strategy? How does this translate into sales credits for Jack? Should Jane be willing to compensate Jack directly for finding good risk? If there’s tons of good risk to be found, how quickly does it experience diminishing value?

These are all hard questions that help us to evaluate the performance of our securities sales and trading business. There’s a confluence of factors here with poorly understood knock-on effects. Fundamentally, the question becomes: “how can we tweak the compensation structure to cause material change in the sales and trading business?”