Without a doubt there will be a lot of gnashing of the teeth over the fact that Wall Street firms are again recruiting commodities traders with promises of $1 million “guaranteed” bonuses. Bonuses paid by banks to their fixed income groups, which typically include commodities, are expected to expand by 40 per cent to 50 per cent this year, according to a New York-based compensation consultant who spoke to Bloomberg.
In the minds of many, the guaranteed bonus makes no sense. There’s the widespread believe that banks should pay employees for performance rather than just showing up. Aren’t the incentives totally warped if the trader is guaranteed to make a million regardless of how well he manages his book?
Not as much as you might think. Traders with guaranteed bonuses often have huge potential upsides. The guarantee is really just a downside cushion that actually accomplishes what it’s meant to: it encourages more risk taking than would be rational if the trader was worried about not earning a dime if the trades went bad. You see, the level of profits demanded by shareholders of financial firms increasingly require banks to raise their level of risk taking. Someone who knows that even if he loses everything he’ll still take home a million bucks can afford to be more daring than someone who is worried about paying his mortgage.
More importantly, it’s just not true that traders should only be paid for returns. Banks are actually paying for something else: exposure to upside potential rather than actualized gains. And exposure to upside is not imaginary. It is, in fact, at the heart of almost all investment activity.
Think of it this way: when you buy a stock, do you only pay for it if the stock goes up? No. You pay when you acquire the stock. And what you are paying for is the exposure to the potentiality of the stock rising or paying a dividend. You pay in advance even though the returns are uncertain, risky and your entire investment could go to zero. Essentially, you are giving the seller of the stock a guaranteed bonus on its performance.
This is exactly what’s happening with guaranteed bonuses. The banks are investing in traders, buying the upside potential. Just because the assets purchased are people’s potential gains, doesn’t mean the same logic doesn’t apply.
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