Does ethics have its place among traders?

Aziza Laguecir, EDHEC Business School and Bernard Leca, ESSEC

However, since what has become the “Kerviel affair”, it would seem that the behavior of traders within the trading rooms (rooms located at the heart of the financial system) has hardly changed, despite increased regulation of markets and financial institutions.

These behaviors have attracted a lot of attention from the media, regulators, financial markets, academics, managers and a wider public unfamiliar with the world of trading. Some authors characterize the behaviors of traders in investment banking as unethical behavior.

In a recent academic article, we show the importance of the organizational context and the sector in these ethical behaviors.

Unethical, a “quality”

Most financial ethics research takes a relatively narrow perspective on unethical behavior by focusing on compliance and adherence to legal and moral standards. This perspective focuses on individual stocks and fails to capture the broader institutional context of investment banking.

Moreover, some researchers argue that traders are by nature unethical people who are attracted to an industry itself devoid of any kind of ethics. According to others, the moral virtues would even be contrary to what is required of traders in the financial sector.

However, it seems important to us to go beyond these two perspectives, on the one hand to consider the broader context of investment banking, and on the other hand to focus on the conditions that would encourage unethical behavior by traders. Indeed, the investment bank would be according to some works a sector rather conducive to unethical behavior. What is considered unethical outside the investment banking industry is actually a “quality” within it.

Adopting this perspective, we suggest that if the constantly tightened control systems do not seem to work, it is because they are perhaps not supposed to limit the action of traders. Indeed, in our research, we show that the control systems of traders’ activities are not designed to control the ethical behavior of traders.

In our view, the design of control systems has three pitfalls that do not allow them to control their behavior as traders. We characterize these pitfalls under the term of physical, technical and social distance.

The physical distancing is the fact that the controllers are physically distant from the traders, in order to respect the principle of separation of tasks and independence. There is also a technical distance between traders and controllers, since the latter rarely master the technical aspects of the former’s activity. Finally, the social distancing between supervisors and traders is due to the fact that the social status (prestige, remuneration and legitimacy) of supervisors is perceived, within investment banks, as inferior to that of traders.

Our research highlights that the way control systems are designed does not allow them to effectively control the behavior of traders but, on the other hand, they allow to give the illusion of internal and external control. Our findings raise doubts about the role of control systems in monitoring trading activities.

Ineffective controls

While this state of affairs continues despite the tightening of regulations and the assertions of banks that such abuses are a thing of the past, some avenues for improvement can be considered.

The first is to better distinguish the different types of controls. We propose to distinguish the forms of controls that can be described as “primary”, from the so-called “secondary” forms.

The primary forms combine the three factors mentioned above, physical, technical and social distance. Secondary control shapes have one or more of these three distances. In investment banking, they notably include risk management and compliance. These secondary forms have little impact on the conduct of operations and therefore on the behavior of traders. However, the changes in the regulations are mainly intended for these forms of secondary controls.

There are other forms of control, which take less formal and legal and more social forms. These primary controls take place at the heart of market activities, in the trading room itself. They involve the heads of the desks as well as the other traders and how they behave towards each other.

However, all the ethnographic studies carried out in the trading room emphasize that the social control that is exercised then is based mainly on competition, the race for financial performance, with relatively little consideration for the risks incurred.

The Kerviel affair provides a perfect example of the importance of this type of control. In this case, a first direct supervisor had detected fraudulent behavior and had called him to order, which highlights the importance, in this context, of an increased role for desk managers, who can control operations and detect anomalies. These managers act as experts, as peers, but also as managers with the physical proximity, the technical knowledge, and the authority to carry out an effective control.

Nevertheless, this technical supervision remains insufficient when the person in charge lacks expertise, expertise essential to the understanding and direct supervision of trading. This was the case with the next manager in charge of the desk on which Kerviel operated, who did not realize the nature and extent of the anomalies.

Peer review?

Another important element is the trading room culture, which is permissive and values ​​profitability and risk-taking more than scrupulous compliance with regulations or ethics. Reinforcing primary controls therefore implies an evolution of both the training and the socialization of traders, in other words the culture of trading rooms.

This evolution would make it possible to develop an additional form of primary control, a control exercised not by immediate superiors but not by peers. In the state of practice, such control exists, in the sense that social control is exercised between traders who observe each other.

However, this mutual control is mainly, if not essentially, about financial performance and the ability of each to outperform the others in terms of profit. In fact, this mutual control turns out to be permissive, even “pushes to crime”. Instead of encouraging moderation, it encourages traders to step up and take more risk, for themselves and others. It is about being able to boast of being better, that is to say often of having fewer scruples, than others, as in the case of the self-proclaimed “Fabulous Fab”.

This offered structured securities sold to clients while concealing from them that the architect of the securities, the fund Paulson & Co Inc., had taken positions against this portfolio of securities. It is also this need to shine that can partly explain the behavior of Jérôme Kerviel, operating on derivative products with fairly low profitability, and despised by traders operating on more profitable products.

A change in these attitudes, towards less unbridled pursuit of profitability would have a decisive effect on the risks that traders expose their employers, their clients and more generally the economy when the sums involved constitute a systemic risk as in the case of subprime mortgages. What is at issue here is not just the internal culture of a particular bank or fund, but more likely a professional culture shared by industry players that places the pursuit of profit notwithstanding risk at the above all other considerations. Consequently, the desirable change would imply that beyond individuals, who sometimes serve as scapegoats, the banks themselves are encouraged to change. We are still far from it.

Aziza Laguecir, Professor, EDHEC Business School and Bernard Leca, Professor of Management Sciences, ESSEC

This article is republished from The Conversation under a Creative Commons license. Read the original article.