The Controversial Topic Of Compensation And Financial Experts

Vincent Glode

University of Pennsylvania – The Wharton School

Richard Lowery

University of Texas-Austin

January 27, 2015

Journal of Finance, Forthcoming

Abstract:

We propose a labor market model in which financial firms compete for a scarce supply of workers who can either be employed as traders or as bankers. While hiring bankers allows to create a surplus that can be split between a firm and its trading counterparties, hiring traders helps to appropriate a greater share of that surplus away from the firm’s counterparties. Firms bid defensively for workers bound to become traders, who then earn more than bankers. As counterparties employ more traders, the benefit of employing bankers decreases. The model sheds light on the historical evolution of compensation in finance.

The Controversial Topic Of Compensation And Financial Experts – Introduction

Compensation in the financial sector has been a controversial topic in recent years. One particular group of workers who tend to earn extraordinary rewards for their expertise are traders in over-thecounter (OTC) markets. For instance, before the recent crisis managing directors trading exotic credit derivatives were making an average of $3.4 million per year.1 More recently, average salaries paid to various types of traders (e.g., commodities, securitized-products) grew by 10 percent in 2014 alone.

In this paper, we propose a labor market model that highlights the importance for financial firms to hire highly talented individuals as OTC traders by offering them seemingly excessive levels of pay. We assume that financial firms compete to hire a scarce supply of skilled workers who can be employed either as bankers or as traders. A banker helps his employer identify profitable investment opportunities while a trader helps his employer value securities backed by the investments of other firms, in case these firms need to trade them for liquidity reasons. Thus, deploying workers to banking raises the surplus that can be split between a firm and its trading counterparties whereas deploying workers as traders allows the firm to appropriate a larger share of that surplus away from its counterparties.

High compensation for traders arises in our model despite the presence of two factors usually presumed to mitigate it. First, the employment of traders is concentrated among very few firms, consistent with evidence of concentrated trading in derivative markets by Cetorelli et al. (2007), Atkeson, Eisfeldt, and Weill (2013), and Begenau, Piazzesi, and Schneider (2013). Second, traders are hired only to strengthen their employers’ position when bargaining with other firms over a fixed pie (hence creating no social value in the model), consistent with Wall Street insiders describing quantitative trading as “war. Us against them” and “sharks devouring one another.” In fact, our model highlights that these factors might have caused rather than mitigated the high levels of compensation observed in finance.

Since a trader’s expertise improves his employer’s ability to extract the surplus in a zero-sum trading game, hiring traders imposes something akin to a negative externality on future trading counterparties (in the sense that the private benefit of such action exceeds its social benefit). This leads to defensive bidding by firms that offer traders what we call a “defense premium” above their internal marginal product. Without such a premium, the traders a firm targets would be hired by rival firms (i.e., potential trading counterparties) and their expertise would be used against the firm in question. Notable, albeit extreme, examples of traders whose hiring was detrimental to rival firms include Josh Levine who pioneered high frequency trading in the early 1990’s and allowed the proprietary trading firm Datek to “out-trade the very best in the business. They could grind Goldman to a pulp. They could make Morgan cry” or algorithmic trader Haim Bodek, whom UBS poached from Goldman Sachs in the early 2000’s “to build an options-trading desk that could go head-to-head with the likes of Hull [Goldman’s electronic trading arm].”

Workers deployed as bankers, however, do not earn as much as traders. When hit by liquidity shocks, firms need to sell the profitable investments their bankers have identified, sometimes at a discount, allowing their counterparties to extract part of the surplus these bankers have helped create. As a result, hiring bankers is similar to providing a public good and bankers earn less than traders. Furthermore, as the number of traders employed by trading counterparties increases, the benefit of employing bankers decreases, resulting in even lower compensation for bankers in equilibrium. On the other hand, as firms employ more bankers and find more profitable investments, the benefit of employing traders who will later value securities backed by these investments increases, resulting in even higher compensation for traders. Thus, not only are two virtually identical workers paid very different wages when they occupy different jobs, but the compensation of a given type of workers is also greatly affected by the employment of a different type of workers by rival firms.

Compensation

Compensation

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