Bill Lipschutz: The Sultan of Currencies

(continued)

What do you mean by "risk control"?

There are a lot of elements to risk control: Always know exactly where you stand. Don't concentrate too much of your money on one big trade or group of highly correlated trades. Always understand the risk/reward of the trade as it now stands, not as it existed when you put the position on. Some people say, "I was only playing with the market's money." That's the most ridiculous thing I ever heard. I'm not saying that all these concepts crystallized in one day, but I think that experience with my own account set me off on the track of considering these aspects much more seriously.

On the subject of risk control, how do you handle a losing streak?

When you're in a losing streak, your ability to properly assimilate and analyze information starts to become distorted because of the impairment of the confidence factor, which is a by-product of a losing streak. You have to work very hard to restore that confidence, and cutting back trading size helps achieve that goal.

With all the loyalty you had to Salomon, why did you eventually leave?

Gil, who started the department, left in 1988, and I ended up running the department for a year and a half. I would find myself talking on the phone a lot-not about trading, but rather about a lot of personnel problems. I was also not crazy about traveling all over. I didn't like managing people in Tokyo, London, and New York.

I wanted to bring someone in as a comanager for the department. I wanted to run trading and let someone else run the administrative side. That's not the style of Salomon Brothers, however. Instead they brought in someone from above me. Initially, I thought that it might work out, but the person they picked had no foreign exchange background at all. He came from the fixed-income department and saw everything in the eyes of the bond world. He would frequently ask, "Gee, isn't that just like the government bond market?" The answer in my mind was, "No, it's nothing like the government bond market. Forget the government bond market."

How does your current trading for your own management firm differ from your trading at Salomon?

At the moment, I'm trading a lot smaller than at Salomon, which is a disadvantage.

How is large size an advantage?

You're kidding.

No, I'm serious.

If a big buyer comes in and pushes the market 4 percent, that's an advantage.

He still has to get out of that position. Unless he's right about the market, it doesn't seem like large size would be an advantage.

He doesn't have to get out of the position all at once. Foreign exchange is a very psychological market. You're assuming that the market is going to move back to equilibrium very quickly-more quickly than he can cover his position. That's not necessarily the case. If you move the market 4 percent, for example, you're probably going to change the market psychology for the next few days.

So you're saying size is an advantage?

It's a huge advantage in foreign exchange.

How large an account were you trading at Salomon?

That question really has no direct meaning. For a company like Salomon, there are no assets directly underlying the trading activity. Rather, over time, the traders and treasurer built up greater and greater amounts of credit facilities at the banks. The banks were eager to extend these credit lines because we were Salomon Brothers. This is an example of another way in which size was an advantage. By 1990, our department probably had $80 billion in credit lines. However, no specific assets were segregated or pledged to the foreign exchange activities.

I would like to get some feeling for how you reach your price directional decisions. Strictly for purposes of illustration, let's use the current outlook for the Deutsche mark. I know that you expect the dollar to gain on the Deutsche mark. What is your reasoning behind the trade?

First of all, I'm very concerned about the effects of unification on the German economy. There are tremendous infrastructure problems in East Germany that may take a decade or longer to solve. Also, the plans to restructure the Bundesbank (the German central bank) to include representatives of the former East German central bank create a lot of uncertainty. Finally, Kohl's government currently appears to be on a much weaker footing. All of these factors should operate to provide disincentives for capital flowing into Germany.

At the same time, a combination of low U.S. interest rates, an apparent desire by the Federal Reserve to continue to stimulate the economy, and preliminary signs of favorable economic data suggest that the United States may be coming out of its recession. Therefore, people are starting to think that the United States may not be a bad place in which to invest their money.

Having established a long-term philosophy about which way the currency is going-in this case, the dollar going higher against the D-mark-how would you then recognize if that analysis were wrong?

Events that would change my mind would include evidence that the German government was dealing effectively with some of the problems I listed before and economic statistics suggesting that my assumption of an end to the U.S. recession was premature-essentially, the converse of the situation I described for making me bullish on the dollar.

For argument's sake, let's say that the fundamentals ostensibly don't change but the dollar starts going down. How would you decide that you're wrong? What would prevent you from taking an open- ended loss?

I believe in this scenario very strongly-but if the price action fails to confirm my expectations, will I be hugely long? No, I'm going to be flat and buying a little bit on the dips. You have to trade at a size such that if you're not exactly right in your timing, you won't be blown out of your position. My approach is to build to a larger size as the market is going my way. I don't put on a trade by saying, "My God, this is the level; the market is taking off right from here." I am definitely a scale-in type of trader.

I do the same thing getting out of positions. I don't say, "Fine, I've made enough money. This is it. I'm out." Instead, I start to lighten up as I see the fundamentals or price action changing."

Do you believe your scaling type of approach in entering and exiting positions is an essential element in your overall trading success?

I think it has enabled me to stay with long-term winners much longer than I've seen most traders stay with their positions. I don't have a problem letting my profits run, which many traders do. You have to be able to let your profits run. I don't think you can consistently be a winning trader if you're banking on being right more than 50 percent of the time. You have to figure out how to make money being right only 20 to 30 percent of the time.

Let me ask you the converse of the question I asked you before: Let's say that the dollar started to go up-that is, in favor of the direction of your trade-but the fundamentals that provided your original premise for the trade had changed. Do you still hold the position because the market is moving in your favor, or do you get out because your fundamental analysis has changed?

I would definitely get out. If my perception that the fundamentals have changed is not the market's perception, then there's something going on that I don't understand. You don't want to hold a position when you don't understand what's going on. That doesn't make any sense.

I've always been puzzled by the multitude of banks in the United States and worldwide that have large rooms filled with traders. How can all these trading operations make money? Trading is just not that easy. I've been involved in the markets for nearly twenty years and know that the vast majority of traders lose money. How are the banks able to find all these young trainees who make money as traders?

Actually, some of the large banks have as many as seventy trading rooms worldwide. First of all, not all banks are profitable in their trading every year.

Still, I assume that the majority are profitable for most years. Is this profitability due to the advantage of earning the bid/ask spread on customer transactions, or is it primarily due to successful directional trading?

There have been a lot of studies done on that question. A couple of years ago, I read a study on the trading operations of Citibank, which is the largest and probably the most profitable currency trading bank in the world. They usually make about $300 million to $400 million a year in their trading operations. There is always some debate as to how they make that kind of money. Some people argue that Citibank has such a franchise in currency trading that many of the marginal traders and hedgers in the currency market immediately think of Citibank when they need to do a transaction-and Citibank can earn a wide spread on those unsophisticated trades. Also, Citibank has operations in many countries that don't have their own central bank. In these countries, much or even all of the foreign currency transactions go through Citibank. The study concluded that if Citibank traded only for the bid/ask spread and never took any position trades, they probably would make $600 million a year.

That would imply that they probably lose a couple of hundred million dollars a year on their actual directional trading. Of course, that would help explain the apparent paradox posed by my question-that is, how can all those traders make money? Am I interpreting you correctly?

Personally, that's what I believe. However, the argument within Citibank would probably be; "We doubt that's true, but even if it were, if we weren't in the market doing all that proprietary trading and developing information, we wouldn't be able to service our customers in the same way."

That sounds like rationalization.

Assume you're a trader for a bank and you're expected to make $2.5 million a year in revenues. If you break that down into approximately 250 trading days, that means you have to make an average of $10,000 a day. Let's say an unsophisticated customer who trades once a year and doesn't have a screen comes in to do a hedge. You do the trade at a wide spread, and right off the bat you're up $110,000. You know what you do? You spec your buns off for the rest of the day. That's what almost every currency trader in New York does, and it's virtually impossible to change that mentality. Because if you are lucky, you'll make $300,000 that day, and you'll be a fucking hero at the bar that night. And if you give it all back-"Ah, the market screwed me today."

Bottom line: If it weren't for the bid/ask spread, would the banks make money on their trading operations?

Probably not in conventional position trading in the way you think of it. However, there is another aspect of directional trading that's very profitable. Take Joe Trader. Day in. day out, he quotes bid/ask spreads and makes a small average profit per transaction. One day a customer comes in and has to sell $2 billion. The trader sells $2.1 billion, and the market breaks 1 percent. He's just made $1 million on that one trade.

In a lot of markets that's illegal. It's called frontrunning.

It's not illegal in the interbank market. He's not putting his order in front of the customer's; he's basically riding his coattails.

So he does the whole order at the same price?

Generally, the first $100 million would be the bank's. That's just the way the market is.

Is there any difference between that transaction and what is normally referred to as frontrunning?

Yes, it's legal in one market and illegal in the other.

That's the answer from a regulatory viewpoint. I'm asking the question from a mechanical perspective: Is there an actual difference in the transaction?

The real answer is no, but I'll give you the answer from a bank's perspective. When I allow you to come in and sell $2 billion in the foreign exchange market, I'm accepting the credit risk and providing the liquidity and facility to make that trade. In exchange, you're providing me with the information that you're about to sell $2 billion. That is not a totally unreasonable rationalization.

How do you move a large order like $2 billion? How do you even get a bid/ask quote for that amount?

I'll tell you what happens. Let's say an order comes in for $500 million or more. The dealer stands up and shouts, "I need calls!" Immediately, among the dealers, junior dealers, clerks, and even the telex operators, you have forty people making calls. Everyone has their own call lists so they don't call the same banks. They probably make an average of about three rounds of calls; so there are 120 calls in all. All of this is done in the space of a few minutes. The dealer acts as a coordinator- the bank staff shouts out bids to him and he calls back, "Yours! Yours! Yours!" all the time, keeping track of the total amount sold. A large bank can move an amazing amount of money in a few minutes.

When you get right down to it, virtually all the trading profits seem to come from profit margins on the bid/ask spread and coattailing of large orders. That makes a lot more sense to me, because I couldn't figure out how the banks could hire all those kids right out of school who could make money as traders. I don't think trading is that easily learned.

You know my pet peeve? Is that trading? Even at Salomon Brothers, where there's a perception that everyone is a trader, it came down to only about a half-dozen people who took real risk. The rest were essentially just making markets. That nuance is lost on most people.

Getting hack to the credit risk associated with the interbank market that you mentioned earlier, when you do a trade, are you completely dependent on the creditworthiness of the other party? If they go down, are you out the money?

You got it.

Has that ever happened to you?

No.

How often does it happen?

If a trade involves anyone who is even in question, you can ask them to put up margin.

Isn't it possible for a bank with a good credit rating to suddenly go under?

Suddenly? No. What is the worst case you can think of? Drexel? Salomon stopped doing currency transactions with Drexel a year and a half before they went under.

Are you saying that there's not much of a credit risk involved?

There is some risk, but does a Conti fail overnight? We stopped trading with Conti five months before the Fed bailed them out.

But someone was trading with Conti in those last few months. Were they just less well informed?

Not necessarily. They were just willing to take the risk. You can be sure that in those final months, Conti was not dealing at the market. At a certain interest rate level, you would lend any bank money. The reason why surprises don't happen is because it's in everyone's interest to know when there is a problem. Therefore, credit officers are very quick to share information whenever they think a problem exists.

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