Double or Nothing: How Wall Street is Destroying Itself

There’s nothing controversial about the claim— reported on by Slate, Bloomberg and Harvard Magazine — that in the last 20 years Wall Street has moved away from an investment-led model, to a gambling-led model.

This was exemplified by the failure of LTCM which blew up unsuccessfully making huge interest rate bets for tiny profits, or “picking up nickels in front of a streamroller”, and by Jon Corzine’s MF Global doing practically the same thing with European debt (while at the same time stealing from clients).

As Nassim Taleb described in The Black Swan this strategy — betting large amounts for small frequent profits — is extremely fragile because eventually (and probably sooner in the real world than in a model) losses will happen (and, of course, if you are betting big, losses will be big). If you are running your business on the basis of leverage, this is especially dangerous, because facing a margin call or a downgrade you may be left in a fire sale to raise collateral.

This fragile business model is in fact descended from the Martingale roulette betting system. Martingale is the perfect example of the failure of theory, because in theory, Martingale is a system of guaranteed profit, which I think is probably what makes these kinds of practices so attractive to the arbitrageurs of Wall Street (and of course Wall Street often selects for this by recruiting and promoting the most wild-eyed and risk-hungry). Martingale works by betting, and then doubling your bet until you win. This — in theory, and given enough capital — delivers a profit of your initial stake every time. Historically, the problem has been that bettors run out of capital eventually, simply because they don’t have an infinite stock (of course, thanks to Ben Bernanke, that is no longer a problem). The key feature of this system— and the attribute which many institutions have copied — is that it delivers frequent small-to-moderate profits, and occasional huge losses (when the bettor runs out of money).

The key difference between modern business models, and the traditional roulette betting system is that today the focus is on betting multiple times on a single outcome. By this method (and given enough capital) it is in theory possible to win whichever way an event goes. If things are going your way, it is possible to insure your position by betting against your initial bet, and so produce a position that profits no matter what the eventual outcome. If things are not going your way, it is possible to throw larger and larger chunks of capital into a position or counter-position again and again and again —mirroring the Martingale strategy — to try to compensate for earlier bets that have gone awry (this, of course, is so often the downfall of rogue traders like Nick Leeson and Kweku Adoboli).

This brings up a key issue: there is a second problem with the Martingale strategy in the real world beyond the obvious problem of running out of capital. You can have all the capital in the world (and thanks to the Fed, the TBTF banks now have a printing-press backstop) but if you do not have a counter-party to take your bets  (and as your bets and counter-bets get bigger and bigger it by definition becomes harder and harder to find suitable counter-parties) then you are Corzined, and you will be left sitting on top of a very large load of pain (sound familiar, Bruno Iksil?)

The obvious real world example takes us back to the casino table — if you are trying to execute a Martingale strategy starting at $100, and have lost 10 times in a row, your 11th bet would have to be for $204,800 to win back your initial stake of $100. That might well exceed the casino table limits — in other words you have lost your counter-party, and are left facing a loss far huger than any expected gains.

Similarly (as Jamie Dimon and Bruno Iksil have now learned to their discredit) if you have built up a whale-sized market-dominating gross position of bets and counter-bets on the CDX IG9 index (or any such market) which turns heavily negative, it is exceedingly difficult to find a counter-party to continue increasing your bets against, and your Martingale game will probably be over, and you will be forced to face up to the (now exceedingly huge) loss. (And this recklessness is what Dimon refers to as “hedging portfolio risk“?)

The really sickening thing is that I know that these kinds of activities are going on far more than is widely recognised; every time a Wall Street bank announces a perfect trading quarter it sets off an alarm bell ringing in my head, because it means that the arbitrageurs are chasing losses and picking up nickels in front of streamrollers again, and emboldened by confidence will eventually will get crushed under the wheel, and our hyper-connected hyper-leveraged system will be thrown into shock once again by downgrades, margin calls and fire sales.

The obvious conclusion is that if the loss-chasing Martingale traders cannot resist blowing up even with the zero-interest rate policy and an unfettered fiat liquidity backstop, then perhaps this system is fundamentally weak. Alas, no. I think that the conclusion that the clueless schmucks at the Fed have reached is that poor Wall Street needs not only a lender-of-last-resort, but a counter-party-of-last-resort. If you broke your trading book doubling or quadrupling down on horseshit and are sitting on top of a colossal mark-to-market loss, why not have the Fed step in and take it off your hands at a price floor in exchange for newly “printed” digital currency? That’s what the 2008 bailouts did.

Only one problem: eventually, this approach will destroy the currency. Would you want your wealth stored in dollars that Bernanke can just duplicate and pony up to the latest TBTF Martingale catastrophe artist? I thought not: that’s one reason why Eurasian creditor nations are all quickly and purposefully going about ditching the dollar for bilateral trade.

The bottom line for Wall Street is that either the bailouts will stop and anyone practising this crazy behaviour will end up bust — ending the moral hazard of adrenaline junkie coke-and-hookers traders and 21-year-old PhD-wielding quants playing the Martingale game risk free thanks to the Fed — or the Fed will destroy the currency. I don’t know how long that will take, but the fact that the dollar is effectively no longer the global reserve currency says everything I need to know about where we are going.

The bigger point here is whatever happened to banking as banking, instead of banking as a game of roulette? You know, where investment banks make the majority of their profits and spend the majority of their efforts lending to people who need the money to create products and make ideas reality?

65 thoughts on “Double or Nothing: How Wall Street is Destroying Itself

  1. Pingback: Double or Nothing: How Wall Street is Destroying Itself » A Taoistmonk's Life

      • How do you get into the position that you’re betting against your bet, and you win either way?
        You may have to provide an example here dude.

        • Price changes.

          This is a very simplified example.

          If the price of 1 oz of September silver is $30 in May, and you buy 100 futures at $30 and then in June the futures price jumps to $60 an oz then you can sell 100 $60 September futures as insurance

          In September, the transaction would look like you buy $3000 of silver now worth $6000, and agree to sell it for $6000, pocketing a $3000 profit irrespective of whether silver goes to $90, or back to $30 or $15.

          The more dangerous equivalent (doubling down) is if you had bought 100 futures at $30 and the price dropped to $15 then you are showing a book loss of $1500, so you might — believing silver is significantly underpriced at $15 — come in and then buy a much larger number of $15 silver futures, say 2000 oz/ futures or $30,000 worth believing that you will make a big profit that cancels out the $30 futures that are now showing a book loss (if silver returns to $20 the new futures you sold will make a $10,000 profit, easily cancelling out the $1,000 loss you would see on the $30 futures you bought). Of course, if the price continues to drop, then you will lose even more money, and if you want to make a profit on the market to cancel out earlier losses you will have to come in with an even bigger trade (say $300,000 of futures at $10, $3,000,000 of futures at $5), etc.

          The chances are that if the price keeps going in the opposite direction of what you think it will, you will run out of counterparties or money, which is what I believe happened to Bruno Iksil.

  2. Pingback: Double or Nothing: How Wall Street is Destroying Itself |

  3. Fascinating-i wonder when all this nonsensical bailout game is going to stop?
    Probably if Soloman Brothers and LTCM wernt bailed out things might have been a bit different?
    You know things are getting ridiculous when bad new comes out and suddenly the market shoots up in anticipation of Hellicopter Ben and another round of QE.

  4. I have only played rouletter a few times and thanks to a psychic girlfriend, ahve come ahead pretty good i.e. number pops into her head, we make a beeline to the casino, and forsat shot bang get the number 36:1. However like in roulette there is house green and you lose the lot if it comes up. Like a Black Swan!

    @AZIZ “If you broke your trading book doubling or quadrupling down on horseshit and are sitting on top of a colossal mark-to-market loss, why not have the Fed step in and take it off your hands at a price floor in exchange for newly “printed” digital currency? That’s what the 2008 bailouts did.”

    Agreed! Basically the Fed is propping up the banks and markets hoping the American consumer can keep the game going long enough to make changes and bail out their mates. We all know this, and the BRICSs know it too. Effectively we are in a pre WW3 scenario where the BRICs are aligning themselves geopolitically. we are in the 30’s again. War will break out eventually.

    BTW I am going 100% gold.

    • Thanks. Barry Ritholtz and Howard Lindzon retweeted it, which personally I think is massively cool.

      Seems (like Tyler) I am at my best explaining finance rather than posturing on politics or macro. Certainly, it gives the different political factions less scope to disagree with me. (This is why ZH has a mixed left/right audience).

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  30. It’s a consequence of fractional reserve banking. As the distortion of the ponzi builds, more and more actions are based on the illusion instead of reality. Money is work traded for work. It can only be a direct one-to-one relationship between individuals. Anything less is a con.

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