Bill Lipschutz: The Sultan of Currencies

(continued)

How did you become successful as a currency trader without any previous experience?

Foreign exchange is all about relationships. Your ability to find good liquidity, your ability to be plugged into the information flow-it all depends on relationships. If you call up a bank and say, "I need a price on ten dollar ($10 million) mark," they don't have to do anything. They can tell you, "The mark dealer is in the bathroom; call back later." If I call up at 5 P.M. and say, "Hey, Joe, it's Bill, and I need a price on the mark," the response is going to be entirely different: "I was just on my way out the door, but for you I'll see what I can do."

As someone brand new in the business, how did you develop these contacts?

One thing that helped me a great deal was that I had a background in options when it was new to the marketplace. "He knows options," they would say. Hell, I didn't know that much about it, but the point was that no one in foreign exchange knew very much about it either. Their perception was: "He can derive the Black-Scholes model; he must be a genius." A lot of senior guys in the currency market wanted to meet me simply because their customers wanted to do options, and they needed to get up to speed on the subject quickly.

Also, I worked for Salomon Brothers, which at that time provided an element of mystique: "We don't know what they do, but they make a lot of money."

Another factor in my favor was that, although I worked for an investment bank, I tried not to act like a pompous investment banker. The typical guys in investment banks who were doing foreign exchange back then were fixed-income types. They were prissy in the eyes of the FX (foreign exchange) guys. They wore suspenders and Hermes ties; they were white-wine-and-arugula-salad type of guys. They were not the go-out-for-pasta-and-dribble-marinara-sauce-all-over-yourself type of guys, which is what the foreign exchange traders basically were. I was really different; my background was different.

I was the first person at Salomon Brothers to have a Telerate at home. They couldn't believe it. "You want a screen at home? Are you out of your mind? Don't you ever turn off?"

I would look at them and say, "Foreign exchange is a twenty-four-hour market. It doesn't go to sleep when you leave at 5 P.M. The market is really there all night, and it moves!"

Is having contacts important in order to be plugged into the news?

Absolutely. Those of us who did well were generally the ones who were accepted by the interbank circle. The traders who stayed aloof tended to be the ones who couldn't make any money trading foreign exchange. These traders would end up calling a clerk on the Merc floor (the Chicago Mercantile Exchange, which trades futures on currencies-an active but still far smaller market than the interbank market) and would say, "So, how does the Swissy look?" What is a clerk going to know about what is actually driving the international currency market? I would be talking to bankers throughout the day and night in Tokyo, London, Frankfurt, and New York.

Were you trading off of this information flow?

That's what foreign exchange trading is all about.

Can you give me a recent example of how information flow helps in trading?

At the time the Berlin Wall came down, the general market sentiment was that everyone would want to get money into East Germany on the ground floor. The basic assumption was that large capital flows into Eastern Europe would most directly benefit the Deutsche mark. After a while, the realization set in that it was going to take a lot longer to absorb East Germany into a unified Germany.

How does that shift in attitude come about? Kohl makes a statement; Baker makes a comment; statistics reveal very high East German unemployment. The East Germans, who have lived all their life under a socialist system, begin saying, "We don't want to work as hard as those West Germans, and by the way, how come the state is not paying for our medical bills anymore?" The investment community begins to realize that the rebuilding of Eastern Europe is going to be a long haul. As this thinking becomes more prevalent, people start moving capital out of the Deutsche mark.

You could have made all those same arguments when the wall first came down.

I don't think many people saw it that way at the time, and even if they did, that's not important. What is important is to assess what the market is focusing on at the given moment.

And the way you get that information is by talking to lots of participants in the foreign exchange market?

Yes. Not everyone is going to interpret things in the same way, at the same time, as you do, and it's important to understand that. You need to be plugged into the news and to know what the market is looking at. For example, one day the foreign exchange market may be focusing on interest rate differentials; the next day the market may be looking at the potential for capital appreciation, which is exactly the opposite. (A focus on interest rate differentials implies that investors will shift their money to the industrialized countries with the highest interest rate yields, whereas a focus on capital appreciation implies that investors will place their money in the countries with the strongest economic and political outlooks, which usually happen to be the countries with lower interest rates.)

Are there any trades that stand out from your early days as a currency trader?

In 1983, in the very early days of currency options trading on the Philadelphia Stock Exchange, one of the specialists was quoting a particular option at a price that was obviously off by 100 points. I bought fifty. Since this was a deep-in-the-money option, I immediately sold the underlying market and locked in a risk-free profit. (A deep-in-the-money option is just like an outright contract, with the added advantage that if the market has an extreme move the maximum risk is theoretically limited.)

I asked my broker whether the specialist was still offering to sell more options at the same price. "Yes," he replied, "the offer is still there."

"Buy another fifty," I said.

At the time, I was the only currency options trader on the Philadelphia Exchange that regularly traded in fifties. The entire daily volume in the market was only about two or three hundred contracts. I did another fifty, another fifty, and another fifty. Then Goldman Sachs came in and did fifty. All of a sudden, the specialist had sold three to four hundred of these options. He obviously thought he had a locked-in arbitrage profit, but he had done his arithmetic wrong. I knew exactly what was happening. Finally, I said to my broker, "Ask him if he wants to do one thousand."

"Just a second," he answered. The broker came back a half-minute later and said, "He'll do one thousand at this price."

The specialist had backed off his offer, but he was obviously still off by almost 100 points in his quote. Finally I said to my broker, "Tell him to call me on my outside line."

The specialist calls me up and says, "What are you doing?"

I respond, "What are you doing?"

He asks, "Do you really want to do one thousand?"

I answer, "Listen, you're off by a big figure on your price."

"What are you talking about?" he exclaims. I start walking him through the numbers. Before I finish he says, "I've got to go," and the phone goes dead.

I got off the phone and thought about it for a few minutes. I realized that holding him to the trade would put him out of business-a development that would be bad for the exchange and terrible for the product (currency options), which we were just beginning to trade in a significant way. I called my broker and said, "Break all the trades after the first fifty."

At about the same time, my outside phone line rang. The specialist was on the other end of the line. "I can't believe it!" he exclaimed, agonizing over the immensity of his error. "This is going to put me out of business."

I said, "Don't worry about it, I'm breaking all the trades, except the first fifty."

(By the way, Goldman refused to break any of the 150 they had done. Years later, after the specialist company had gone out of business, and the individual specialist had become the head trader for the largest market maker on the floor, he always made it very difficult for Goldman on the floor.)

My action of breaking the trades represented a long-term business decision, which I didn't think about a lot at the time, but which I agonized over for years afterward.

Why is that?

I have a reputation as being one of the most-if not the most-hard-assed players in the market. I never, ever, ever, ever, cut anybody a break, because I figured that at Salomon everybody was trying to knock us off. I was sure that if the tables were reversed, no one would ever give us a break. My view was always that these are the rules of the game. I don't give any quarter, and I don't expect any quarter.

Traders would sometimes call up when they had just missed the expiration of an over-the-counter option that went out in the money. There were a million excuses: "I tried to get through earlier." "I forgot." "I'm only a few minutes late, couldn't you just make an exception?" I always knew that if we called late, no one would let us exercise. The fact is, in all the time I was there, we never missed an expiration. The argument I made was, "Look, we've put a lot of money and thought into our back-office operations. We've instituted numerous fail-safe measures to make sure that we don't make mistakes."

When I was working out the management company details with Merrill, they asked me how much they should budget for back-office errors. I said, "Zero."

They asked in disbelief, "What do you mean by zero?"

I said, "Zero. We don't have back-office errors."

They said, "What do you mean-of course you have back-office errors."

I answered, "No, we don't make errors. If you put in enough fail-safes, you don't make errors."

That was my attitude, and that was why I wouldn't break the rules. People who knew me really well would say, "Lipschutz, why do you have to be such a hard-ass about everything?" I would simply say, "Hey, these are the rules; that's the way the game is played." So for me, letting the specialist off the hook was very much out of character.

Did you decide to give the specialist a break because it was such an obvious mistake? Or because you thought it might threaten the longevity of what was then a fledgling exchange and product?

It was a long-term business decision based on the opinion that it would have been bad for my business to hold him to the trade.

Bad for your business in what way?

My business in trading currency options was exploding, and the Philadelphia Stock Exchange was where they were traded. (The over-the-counter currency options market was only just starting at the time.)

So you did it more to protect the exchange.

No, I did it to protect me.

To protect your marketplace?

That's exactly right.

Then, hypothetically, if the exchange had been there for ten years, trading volume was huge, and this trade would not have made any difference to the survival of the exchange, you would have made a different decision.

That's correct. It wasn't charity.

So the fact that it was such an obvious error...

No, that wasn't the motive, because I said to the broker, "Ask him to check his price." "Ask him if he is sure." "Ask him if he wants to do another fifty."

In the interbank market, don't the dealers sometimes inadvertently quote a currency off by one big figure-for example, the real price is 1.9140 and they quote 1.9240. Do you hold a dealer to the quote even if it's an obvious mistake?

The convention is that there has to be an honest attempt. Let's say that some news comes out and the market is moving like crazy. You may not even know what the big figure is. Assume a dealer quotes 1.9140, and you think the price should be 1.9240. The convention is to say, "1.9140. Are you sure? Please check your price." And if the dealer responds, "Yeah, yeah, yeah, I'm sure. Do you want to deal or don't you?" then the price should stand.

Has this happened to you?

Yes, and I can tell you that every time that it has happened, the other institution has come back and either wanted to cancel the trade or split the difference.

And what did you say?

I refused, because I had asked them to verify the price.

There is a break in the formal interview to devour some Chinese food that we have ordered in. During the meal, we continue to discuss markets. One of the subjects discussed is clearly stated to be off the record, because it contains a number of references regarding one of the exchanges. Since I believed that the comments and viewpoints expressed in this discussion would be of interest to many readers, I eventually prevailed on Lipschutz to permit the use of this conversation. In accordance with this agreement, I have edited out all specific references to the exchange, market, and traders.

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