Flow, in the form of regular buy and sell orders, is what every trading desk is after, pretty much in any asset class or product. The greatest “flow” I have ever encountered has to be secondary FX at a Swiss bank; all those private clients buying securities in many different currencies. Manna from heaven, or more precisely multiple hundreds of millions of easy P&L driven by spreads so wide you could drive a truck through them. Cash equities is another one of those “flow” businesses. Now today, the commissions are pretty small, but the volumes can be higher. Now back in the ’90’s, those commissions could be as high as 50 basis points. That’s 0.50% for those who don’t do “bips” for a living.
One of the regular flows in an investment bank is the cash equity trading to support its derivatives. This particular tale involves the hedging of warrants using equities and a so called delta hedge. In simple terms this means that a bank has sold a warrant, normally the kind hat allows the holder to buy something at a fixed price up to a point in the future, betting that the market price will be higher. All traders of this kind of instrument will hedge, or protect themselves, by buying some of the underlying stock. One team I serviced in the past had their business set-up with a head trader in London using a local in country junior trader to trade the warrants in the local market and to execute the daily changes in the stock position. That daily stock position was fairly juicy business for the local brokers; on a weekly turnover of some $100 million, they were in for commissions of maybe $500’000. A nice little earner, as Arthur Daley might put it, or money for old rope as Mickey Clarke from BBC Radio 5 Live would likely put it. So, as you might expect, there were a lot of brokers knocking on the door looking for a piece of the pie.
Now humble Operations oik that I was at the time, where exactly the traders decided to direct their equity trading was of no interest at all to me. “Give me 100 trades, I’ll settle them, give me 50 trades, I’ll settle them!” So goes the mantra of the average Ops guy. So that went, until one day, I got a call from the equity derivative head trader, Neil, a Scouser with an accent so thick it made the average English Premier League Footballer look intelligent. Neil wanted some help looking into the flow of equity trades. Now as a typical Ops guy, even then, you might only look a particular trade or two if they somehow stuck out as exceptions. Most of them were not touched by human hand. A couple of reports and a few hours on Excel later, we had a view of activity by account over time. Sure enough, one local broker appears a bit more than we might expect. Otherwise, the brokers and respective volumes were the “usual suspects”. Now it turns out that there was a connection between the local broker, who was happy putting a few million per week in order for a nice commission of 50 bips in his pocket, and our local junior trader. Brothers. Now, this turned out to be nothing more than a favour and a bit of poor judgement on the part of our junior trader. So words were had, with the junior being told that his head trader was allocating cake and local discretion was not on the menu.
Trust is good, control is better. So, over and above having a word in the ear of his junior, the head trader asked me to run this brokerage report each week and give him a view of whether things were as we would expect. Only took a couple of weeks and I knew that a normal week had turnover of 100 million, a slow one of 50 and busy one of 150 million. And, as the report showed me which broker saw how many trades and how much volume, I knew at a glance if the “usual suspects” were getting their weekly flow. Good news, the oversight worked. Job done, lesson learned.
Some time after this, I moved on to work in a different office and sometime later met up with an old colleague who was now the office manager. Over coffee, he told me of some problems with the local junior traders for the equity warrant team. Seems that the latest junior trader had been up to no good. Now, some readers will be old enough to remember Superman I and the opening scene, where some suits in a corporate office are musing how they will catch the “person who has been ripping off the 1/2 cent differences in accounitng”, just as the zany Richard Pryor, a very junior nobody, pulls up into the car park in shiny red Ferrari. Not just a red Ferrari, but a proverbial “red flag”. Well back to the real world, sure enough this latest junior trader was turinng up to work in a Lamborghini Diablo. Way out of his pay league and enough to arouse some curiosity. Well a little digging later, the office manager discovers that this Lamobo driving junior had asked one of his colleagues for help building a spreadsheet to track commissions. Now the mind boggles as to how our fast car driving young lad could not multiply quantity by 0.50%, but that only implies one degree of stupidity. Actually it turned out this young trader had a PhD in stupidity, because this colleague-assisted-spreadsheet was actually sitting on the company network with the list of trades with a particularly obscure bank in Lugano. So, the office manager calls up this place in Lugano and asks to speak to the Head of Complinace. “Che Cosa e?”. More chance of ringing the White House and asking for the President. So, what my office manager had was a lot of what one would call circumstantial evidence, but nothing to prove any connection between the trades and the newly acquired Lambo. So words were had, bonuses were docked and life went on. As we sat drinking our espressos, I could not help smiling and asking my office manager whether after I left, they were still looking at the weekly brokerage reports. “Which reports exactly?” I was asked, somewhat to my consternation.
Lessons Learned: Understand the business you look after. What is normal in terms of volume and who your traders do business with? Is what you saw last week typical, is there a massive exception or perhaps one that repeats itself? Once you do have the sort of controls you feel comfortable with, make sure you use them and them being run is not a function of you being in the office to do them.