Derivatives: Making Sense of Where We Are

The world of derivatives is in a purgatory state--a prolonged holding pattern until regulators finally finish new rules that will govern how they will be sold, traded, valued, cleared and reported. Regulators and financial institutions in the industry have dragged their feet in annoying, painstaking ways. What will eventually happen to how they will be traded?  How will be big banks respond? What will they do? When will the industry decide?

How will banks compensate for the billions in revenues that could evaporate when the derivatives playing field is re-landscaped?

The stories have  been told often over the years how derivatives markets have surged and soared, how derivatives have become a market of trillions (measured by the "notional" or face value of the derivatives traded globally).  The credit-default-swaps market is said to be over $25 trillion. (That would be "notional" face value, not actual market value or market outstandings.)

The story is also told often about how derivatives markets are opaque, sometimes illiquid, often misunderstood or too complex and how markets are dominated by banking behemoths that dictate pricing spreads, trading procedures, collateral requirements and who gets to join the inner circle of dealers.

WHAT REALLY IS A "DERIVATIVE"?

"Derivatives" is a financial term that today encompasses a wide range of financial activity. The term was rarely used before the mid-1980s, although some forms of derivatives have existed for as long as there have been viable trading markets.  In current times, a derivative might include almost any financial instrument that is influenced by market risks and credit risks, but is not a director investment into a corporate entity.  In other words, it encompasses all that is not an equity investment, a plain-vanilla bond, or a loan. 

Derivatives, by convention, include options of all kinds (puts, calls and collars), convertible bonds (and other "hybrid" instruments), interest-rate swaps, credit-default swaps, equity-linked swaps, commodity swaps, index trading and index swaps, and currency swaps.  They include futures trading--those traded on

exchanges and those traded "over the counter."

Frequently, derivatives will include forward foreign-exchange transactions.  For most in finance, the term will include mortgage-backed securities, CDOs, CLOs, IOs, POs, CDOs squared, synthetic CDOs, and synthetic CLOs, And if we dare get fancy, they include swaptions, "knock-out" swaps, and CAT (catastrophe) bonds.

Derivatives creators adore acronyms, complexity, quantitative analytics and the lure of something new and different.  Derivatives managers enjoy the open-round gush of profits.  Financial theorists and financial engineers embrace whiteboards of equations and calculus that try to define the behavior of these instruments.

Derivatives, the term, captures just about any complicated instrument that doesn't sound like a stock, bond or loan.  The finance media define derivatives as financial instruments "the value of which are based on other securities and instruments"--a catch-all phrase that often doesn't explain exactly what they are or how they perform in live markets.

THE APPROACH OF BIG BANKS AND DEALERS

Here is how large banks and hedge funds that have dominated prominent segments of the market define and approach derivatives--at least until now, while the global business model for trading derivatives is under threat:

1.   The first institution to conceive, create, build a model, sell, and trade a new derivative gets to determine and mark the playing field or the "rules of the game."

2.  The first few firms, usually large banks, that leap into the arena of a new derivative product determine the profit dynamics--how profit margins and spreads are determined, how positions are valued, and how prices are reported. Therefore, they become the core of large dealers that dominate the new market at the outset.  They will behave in ways to ensure they maintain control of the market--especially the lucrative pricing spreads.

3.  The large dealers who control the market decide when and how to open it up to new clients and counter-parties.  This permits the new market to grow, boosts liquidity, and spawns a large number of "end-users," who often use the derivative for risk-management or hedging purposes.

4.  The large dealers and their inner circle will design the marketplace such that the growing number of "end-users" (corporations, manufacturers, small funds, and individuals) must arrange trades by going to one of the large dealers.

5.  Large dealers, banks and hedge funds are able to maintain control of markets (and profits) because of advantages in capital resources, systems and technology, and information.  They can survey, see, comprehend and act upon all the activity that occurs around them.

6.  Large dealers, because they control pricing, spreads, and profits, have little incentive to change the status quo, except to increase activity and liquidity and reduce counter-party risk (the risk of clients and counter-parties defaulting on trades).

7.  Once they understand the new product and market behavior, speculators abound and will pounce on any opportunity to take advantage of market abnormalities or inefficiencies. They will likely be specialized hedge funds and funds that house "quant-jocks," but they may also (at least in the past) be the proprietary trading units of large banks and dealers.

8.  Large dealers, because they control the market, can determine the price reported among themselves, prices reported to other interested end-users, and prices reported to the public.

9. Large dealers determine, as they see fit or with guidance from regulators, how the transactions are "cleared" (settled, paid for, or consummated formally) and how they protect themselves from "default risk" by setting rules for how end-users participate (for example, by pledging collateral or requiring they meet certain capital standards).

Large banks and dealers claim they haven't managed these markets ruthlessly. They argue there has been sufficient self-policing and adequate oversight from regulators and industry-related organizations.  (ISDA, for example, is an industry association that continues to set common standards for trading, documentation, reporting, and collateral-pledging. Markit is an independent company that offers pricing services.)

Then came the financial crisis.

Then came the public's charges that improper selling and trading of derivatives explains why the crisis unfurled and infected much of the global economy. 

Then came Dodd-Frank legislation and regulation.  Dodd-Frank was a comforting anecdote to the crisis. It had the right themes and provided outlines to make markets safe. But Dodd-Frank didn't stipulate tough  deadlines. 

Armed with Dodd-Frank powers, regulators have a blueprint and a vision for how derivatives markets should be overhauled.  They have been tardy, however, in writing the thousands of rules, line by line, that will redesign markets from front to end.  Because derivatives are amorphous financial instruments and don't fall easily into categories, regulators fuss among themselves about which body should have the most oversight.  The debates among the SEC, the CFTC, the securities and derivatives exchanges (NYSE, ICE, NASDAQ, CME, etc.) are part of the reason for delays.  The Federal Reserve, FDIC, FHFA, and OCC have opinions, too.  An alphabet smorgasbord of sometimes conflicting input.

In  spirit, regulators seek to require most commonly traded derivatives be bought, sold, traded and reported on a major exchange with pricing and dealer transparency rules.  Commonly traded derivatives must be cleared and settled (all post-trade operations) via an approved, recognized arrangement, usually funnelled through large well-capitalized banks and overseen by established clearinghouses.

Regulators knew, too, large dealers and banks weren't going to sit still and let millions/billions in profits wither away. Until banks figured out a way to re-engineer their business models to generate profits while strapped by new rules, they would stall the implementation of regulation and continue to squeak out profits. Or they would retreat to their finance labs to craft other ways of making money from derivatives dealing.

WHAT'S ON THE HORIZON?

Where are we now? Where do we go from here? Will reforms do what they are intended to do--reduce risks in the system, reduce the likelihood that trading won't implode into market nightmares, and prepare institutions for the next crisis?

1.  Banks are rebuilding their derivatives-trading desks, reorienting them toward customer activity and customer flow and allocating proper amounts of capital to support them, as required by Basel III regulation. Some banks are downsizing their desks, not able to make economic or regulatory sense from the wave of regulation.

2.  But big banks won't go away sheepishly.  Revenues from derivatives soared until the late 2000s. They will continue to eke out profits until the economics and capital requirements dictate that old models make no sense.  The biggest and best dealers (including Goldman Sachs and JPMorgan) will develop new, different business models to generate profits. 

3. Massive regulation, oversight and public concern will discourage banks and hedge funds from creating new derivative products--at least not as rapidly as the 1990s and early 2000s, when new products flew off the shelves.  Not long ago, large banks seemed to roll out a fancy new acronym for a new product every other quarter, always a moment of pride for them and for the quantitative experts they had hired to think them up.

4.  Regulators, in an effort to come to a conclusion soon, will unveil new rules (thousands of them), but will probably soften some of them, compromising with banks and hedge funds, yielding to some of their unrelenting lobbying efforts.

5.   "Pain vanilla" activity (basic swaps, basic forwards, will thrive, even with thinner profit margins. The big banks will compensate with volume and take advantage of other banks exit derivatives activities.

It will have been a long haul, and it won't be over soon. Derivatives markets are huge, impactful, and complex.  This story still has many chapters remaining.

Tracy Williams

See also: 

CFN: Cliffs, Reform and Recovery, 2013

CFN:  Libor in Crisis, 2012

CFN:  High-frequency Trading: What's Next? 2012

CFN:  The Big Short and Credit-Default Swaps, 2010

CFN:  MF Global:  Too Small to Save, 2011

How Will Steven Cohen's Saga End?

Should investors take the money and run?

If you were fortunate to invest in Steven Cohen's hedge fund, what would you do? Keep the faith, and keep your funds in SAC Capital Advisors?  Or take the money and run, while government investigators pore through trading records for evidence of insider-trading?

How will the SAC Saga end?


Tucked away along I-95 on the winding hedge-fund corridor in Connecticut is the home of the closely cloaked $14 billion hedge fund run by Cohen.  In the world of quantitative trading and hedge-fund investing, Cohen's SAC Capital is well known, envied by many, desperately copied by others, and revered by most in the investment community. These days, the fund is known outside the hedge-fund world because of  the investigative cloud that lingers above it.

Since its 1992 founding, an obsessed Cohen permitted few to learn about his fund's operations, performance, and trading strategy.  For most of the fund's existence, Cohen avoided public appearances and showed up nowhere if media appeared, except for arts and charity events. (His investments in art are legendary.)

He refused to let others take photos of him. The New York Times or Wall Street Journal published over and over the same one or two photos it could find of him in articles that chronicle the fund's history. The industry factions that follow, watch, report and try to ape his successes hardly knew or understand what went on inside. Forbes magazine estimated his net worth recently to be about $8 billion. The fund eventually reached $14 billion under management.

Nowadays headlines of SAC appear routinely in the financial press. Photos of Cohen accompany many news stories, and his face has become more familiar.  News about the fund has been sour for much of the past year or two, because the news is primarily about insider-trading investigations. 

SAC made its billions from equity trading.  Under Cohen's direction, the fund sponsors many strategies, including high-frequency trading (searching for price anomalies around the globe), fundamental and value trading, and quantitative analysis.

Former analysts, traders and researchers at the fund--after they have departed or were dismissed--have divulged morsels of SAC intelligence.  Cohen is the quarterback and captain of all trading activity, his hands always involved, his voice wielding a final say-so in trading positions and strategies. He grooms strategies, hires stalwart traders, and entrusts them with significant amounts of capital, permitting them to try out their ideas or execute their trading views.

But he was said to be harsh if performance waned or fell shy of his expectations.  He pushed traders hard, not merely to "seek alpha" (as the hedge-fund jargon goes), but to out-perform even the toughest fund benchmarks. Traders are dismissed swiftly if they don't meet targets.

Traders felt the pressure to find an edge, a trading strategy or a performance trend that would please the boss.

Over the past few years, some former traders have been accused and indicted of insider trading at funds they managed after leaving SAC. Some former employees have been accused of illegal trading while at SAC Capital.  The SEC continues its investigation of trading under Cohen's supervision. He has insisted throughout he is innocent and, in recent months, has delivered strong statements assuring investors that from his top perch he has applied tough discipline to make sure the firm stays within legal lines.

Meanwhile, regulators and law-enforcement officials comb through, around and about SAC.  SAC Capital and Cohen may never be charged of anything, but right now, a stench hovers above the fund and seems to have settled there for a long time to come.  Some investors want out--now. The typical redemption rules apply. Investors can get out, but only after applying for withdrawals and then allowing their monies to trickle out over time. 

With investigators in its backyard searching through voluminous trading records, what will eventually happen to the fund? Why would investors want to hang around and leave large amounts of money with Cohen? He has an impressive performance record, but will he admit that he is distracted by the legal cases and investigations around him?

What does an investor do? There are two or three options.

1) Get out now or when redemption rules allow. 

Certain institutional investors (perhaps pension funds and public funds that answer to a broader community) will flee, because they will not want to explain to stakeholders why they are allied with a fund where illegal activity might have occurred and where there exists the possibility, even if remote, that the fund's founder will one day be indicted like some former employees.

2)  Assess the likelihood that Cohen will one day be charged, an event that would likely lead to the subsequent wind-down of the fund.

If that assessment exceeds 50-50, wage the bet that the fund will continue and, with distractions beyond it, performance will resume at stellar levels. Because there are and will be redemptions, Cohen may scale down the fund, reduce the number of strategies, and make itself nimble.

3) Assess the worst-case scenario:

Cohen is charge and indicted, and the evidence is strong enough for a conviction.  The fund would likely wind down. But markets, regulators, banks and investors must weigh the impact of a liquidation.

Would the impact cause as much market chaos as the frightening collapse at Long Term Capital did in 1998. Its stunning, sudden implosion pushed markets to the brink of apocalyptic turmoil and forced government overseers to assemble a bank group to help settle the chaos.

In this case, would regulators step up in the same way to ensure the disposition of assets, positions and employees is handled in an orderly manner and with minimal impact to markets? Or would a group of neighboring hedge funds, down the expressway in Connecticut, sweep through to bid for the portfolios and positions and hire its expert traders?

Stay tuned.  This is a summer-time saga, likely to drag out through the fall and long enough to bore most market observers, until one day months from now government investigators surface one late Friday afternoon to catch everybody off guard with surprise announcements.

Tracy Williams

See also:

CFN: Ray Dalio's Cult at Bridgewater Associates, 2011
CFN:  Quants and Quant Funds, 2010

High-Frequency Trading: What's Next?

Let's pause for a moment, if the lightning pace of high-frequency trading permits us to do so. In the U.S. today, high-frequency, electronic, computer-aided trading accounts for as much as 65 percent of all stock-volume activity.

Computers whiz and hum.  Black boxes send out trading orders in thousands and millions of shares, and rout orders to exchanges and "dark pools" all over the globe. Execution occurs in fractions of a second. Algorithms and programs determine what to buy, when to buy, when to sell, when to buy and sell at the same time and on which one of a dozen or more electronic exchanges. Algorithms provide guidance on volume, prices to show, prices to execute, and prices, if only for a few seconds, to report as "bids" or "offers."

High-frequency traders dart in and out of trading positions in seconds. Some firms buy in one venue and sell in another. They earn pennies per share, but generate large profits via big volume--tens of thousands of shares bought and sold in seconds. Tens of millions of shares throughout the day. Many buy or sell shares in one venue and simultaneously sell or buy the related derivative over the counter, in another country, or in exchange thousands of miles away. Execution and profit-generation are confirmed by the flickering of light on computer screens. 

Traders--or actually, their humming black boxes--study patterns, trends and data. They look for discrepancies, distortions, or something out of line. Traders (yes, humans, often quantitative analysts and experts) update computer code and write more algorithms to instruct their firms to deploy more capital to get into and out of trading positions in seconds. Timing is of the essence. 

Many aim to finish the trading day with neutral positions--little or no overnight risk. Some preside over non-stop trading--trading into and out of positions, making markets, and providing bids and offers all over the globe for a continuous 24 hours.

Some trade other "asset classes," as well, exploring similar opportunities in instruments beyond equities, looking to do the same or find discrepancies and trends in foreign currencies, options, convertible bonds, and government bonds. Or they seek to decipher relationships between "asset classes" (convertibles and equities, bonds and mortgages, options and equities, interest-rate derivatives and bonds). Most trade for their own accounts; many trade or execute for customers and clients.

Over the past several years, they have  include such firms with unfamiliar names as Getco, Jump, Allston, Gelber, Jane Street, Sun and Quantlab. They also include hedge funds and clients of hedge funds and asset managers. Occasionally they may include other types of funds (investment funds, pensions and endowments), all looking for an advantage based on rapid execution and "best prices."

In the realm of finance, some say this is exponential progress. Compare to the more docile manner of trading in the early 1970s, when stock certificates were exchanged, counted, bundled, boxed and rolled into the vaults of brokerage houses all over Wall Street from day to day, creating such a paper-work crisis that the industry once days off to recover from the mounds of paper.

Others say this represents a setback for retail investors or value-oriented investors. Is anybody among the throngs of high-frequency traders buying stock to support a company's investment in a new business, investment in sales growth, or investment in expansion to a new region of the country?  Do they care for more than a few seconds about a company's new-product strategy or its business plans for 2013?

Many high-frequency firms rebut that they contribute to capital markets in several major ways:

(a) They provide market liquidity, active markets, and ready buyers and sellers.

(b) They provide "price discovery" with bids and offers updated continuously during the trading day.

(c) They provide "best prices," opportunities for buyers and sellers to search venues to find the best price for a particular stock.


Their detractors argue they hamper markets in many ways:

(a) Unlike the stock specialists in the past, they disappear when markets become too volatile. They balk or refuse to participate at certain times.

(b) They don't always provide honest, good-faith bids and offers. Sometimes they show their hands and wander away before execution.

(c) Skipping from venue to venue (electronic exchange to electronic exchange) with less-than-sincere bids and offers, they often try to trick or deceive markets to gain information advantages--advantages that slice profits from retail- and long-term investors.


And they cause what happened in May, 2010:  the "Flash Crash," when the market fell (Dow Jones) almost 1,000 points (9 percent)--a precipitous, unfathomable, and bizarre collapse in minutes for no explained reason. Perhaps just as odd was the market's subsequent rebound the same day.

It took months for market experts, regulators, and exchange officials to figure out what happened. Some still don't agree. Most worry that flash crashes, in this new, 21st-century trading environment, will appear regularly. Many are concerned about the impact of a market (or markets covering all asset classes and many geographies) on individual investors. What are the virtues and attractions of a marketplace where the better capitalized electronic traders appear to have an ongoing advantage, where these traders get access to the best prices and best execution, and where 1,000-point, unexplained drops in the Dow are regarded as by-products of the game?

Over the past year, we've seen other debacles and unexpected turmoil in equity markets.  BATS, an electronic exchange, widely known for its swiftness in execution and the technology that supports it, botched and then canceled its own IPO offering earlier this year--because of technology glitches.  This summer, Knight Trading, a market-making firm, botched an electronic-trading vehicle that was intended to allow even retail investors to have better electronic access at the New York Stock Exchange. That led to losses over $400 million and several days of its existence in jeopardy.

What will happen next? And to whom? Will there be another collapse of some kind, something unpredicted, unexpected out of nowhere--blamed on high-frequency traders, but inexplicable or puzzling to the public at large?

Where do we go from here? Do we allow the marketplace by itself to resolve these quirks, collapses, and unpredictable swirls? Or should regulators (from Congress to the SEC and CFTC) rush in to take steps, even as they try to understand trading models that are racing a hundred steps ahead of them. 

Attempting to understand their trading schemes (their intents, purposes and profits) can be a mind-boggling exercise for those who contemplate regulation. What are their strategies?  How do the translate strategies into profits? How do they allocate capital? While the black boxes hum away, how do senior managers stay on top of the activity? Perhaps most important, how do they approach and manage risks--risks to their firms and risks to counter-parties and other traders and investors in the market?

No one knows for sure what the right next steps should be--at least in the U.S. Should there be transaction fees or taxes to restrict such activity? Should there be increased capital requirements for participants--as protection against what would likely be yet the next big loss or flash crash?  Should regulatory review boards approve all trading strategies and trading innovation?

Many of the same trading firms preside over or direct trading into what are called "dark pools"--private in-house marketplaces where electronic firms can exchange thousands of shares without having to let public markets see what they are doing. In some ways in the industry, it appears what could happen next--near month or next year--is like wandering into an unknown, uncertain "dark pool.

We're likely at a precipice.

Technology innovation will continue, as long as there are profit opportunities. Some argue profit margins will decline as the number of participants increase, and that in itself could slow down the rush to be the fastest in executing trades on the planet.  With other priorities on their plates (Dodd-Frank and Basel 3, most notably), regulators won't be able to catch up quickly, always hustling from several steps behind, panting while trying to project what is the worst that could possibly happen.

Meanwhile, feeling disadvantaged and sometimes clueless, worn down by the equity-market tumult from the crisis, retail investors seem to have decided to watch this play out while they remain on the sidelines.

Tracy Williams

See also:

CFN:  Dark Days at Knight Capital, 2012
CFN:  Market Volatility, Can You Stand It? 2011
CFN:  Uncertainty in Markets, 2011
CFN:  Here They Come, the Volcker Rules, 2011

Firm Culture: Could You Work Here?



Dalio of Bridgewater Associates

 Bridgewater Associates is a successful, $90 billion hedge fund, located along the Connecticut corridor where other successful, gargantuan hedge funds have a home base. Ray Dalio, a Harvard Business School graduate, is its founder and leader. The fund's investors include pension funds and university endowments.

Over 1,000 people are employed in a variety of roles.  It recruits those who are tough-skinned, highly motivated and interested in a long-term career at the fund. MBAs in finance would no doubt be attracted to an opportunity there.

Would you want to work there?

Would it be a place where you can find a niche, thrive and be successful? Would you be able to endure hardships and demands to perform well? Would you be able to stomach equity volatility, risks of losses, and virulent market turmoil? And would you be able to perform under pulsating pressure and high expectations?

Bridgewater is also known as a fund that operates based on a set of cult-like principles, written and often updated and revised by founder Dalio.  "The principles" had been rumored and talked about for a long time. Before they were public, former employees, managers and investors mentioned them. They told tales of employees (traders, analysts, and researchers) being subjected to tough, unrelenting, bruising criticism--as required by the principles.

Dalio, perhaps tired of speculation about whether the principles exist or not, eventually decided to post them (all 122 pages) on the firm's website for all to see. (See  BRIDGEWATER-PRINCIPLES) There they are, to be seen and studied by competing funds, prospective employees, and academic experts in business strategy and corporate organizations.

In the world of hedge-fund blogs and chatter, some say Bridgewater is not a culture, but a cult. Others say if the firm is successful (having attracted talent and experience and having survived the financial crisis), then it's not a cult, but an organization whose culture might be replicated by other funds, institutions and organizations. Others who have worked there speak (anonymously) of having had demoralizing experiences or or having endured debilitating asssessments of their work.

Dalio is unapologetic. "We maintain an environment of radical openness," the Bridgewater site states. "(That) honesty can be difficult and uncomfortable."  Sharp criticism and open discussion, he explains, help people improve, which helps the firm be consistently profitable. There is pain, but there is ultimate gain for all.

Are there, however, costs to such success and consistent performance?  Bridgewater, as a private fund, does not report results and doesn't have to (except to investors and, even then, occasionally and in the manner it chooses).  As a reputable hedge fund with billions under management, fund managers, traders, analysts, researchers, and new MBA recruits are well-compensated. Yet at what costs?

How would a Bridgewater culture differ from the vaunted, well-examined cultures of such firms as GE and Goldman Sachs? If it works at Bridgewater, can it work in other industries? For new MBAs, how important is culture in evaluating a prospective employer?

Some outsiders say employee retention is low at Bridgewater. It's not unusual for 30-40% of those hired to  leave within the first few years. Some ex-employees say the smothering criticism starts during interviews, where interviewers crush prospects with analyses of weaknesses and deficiencies.

Dalio contends it works and suggests that employees who understand and absorb the principles thrive and benefit in the long term.

Bridgewater's principles, as they appear for all to see and examine, aren't corporate-polished. They are bluntly presented. They are ruminations from Dalio--imperative statements based on experiences in the past and based on what has worked for him the past three decades. They boil down to understanding reality, not hiding from it, identifying mistakes, learning from them, and using them to get better. Identifying, exposing and calling out mistakes boldly, brashly, and purposefully. That's where it gets uncomfortable.

Bridgewater is susceptible to being called a cult, because the principles are presented as a one-way stream of thoughts from its founder. The principles never address the details of Bridgewater's fund business. They expound on goals, planning, and behavior. Nothing about capital, risk management and asset allocation; nothing about arbitrage, currencies, technicals, trading momentum and value-investing.

Some of its principles make sense--at least for this type of organization, a large hedge fund required to make trading and investment decisions in swift-moving markets. They may work for a fund, but not for a manufacturer, an industrial complex or a conglomerate.

The principles address decision-making--a critical element in hedge-fund trading and investing fund capital. What are the goals in making decisions? How should decisions be made? How can the fund ensure that people will make the best decisions on behalf of the fund?

The principles discuss goals. Reaching goals requires identifying and solving problems. And solving problems requires harsh, candid assessment of employees. "Once you identify your problems, you must not tolerate them," Dalio writes. Diagnose the problem, he says, and solve them--even if it requires upsetting employees. After goals and problem-solving, the principles address planning and execution.

Some of the principles are reasonable and well-rationalized.  For example, Dalio says managers should obsess in putting people in the right roles, increasing the probability they can succeed.  He says in evaluating employees, pay for the person and not the job; weigh an employees' values and abilities more than skills.

Dalio says, "In our culture, there’s nothing embarrassing about making mistakes and having weaknesses....At Bridgewater people have to value getting at truth so badly that they are willing to humiliate themselves to get it." Elsewhere, he says, "(E)valuate (employees) accurately, not kindly."

As an MBA in finance (with or without experience), could you work and thrive in this environment? Would potential compensation and experience offset possible personal humiliation?


He values communication, even excess communication to ensure everybody throughout the organization understands goals, issues, and corrective action. He values managers, employees, and colleagues maintaining healthy, tight relationships with each other, making it easier to evaluate the performance of each other.

In 122 pages, almost all aspects of management and organization behavior are covered--from performance metrics to firing employees (when they exhibit no potential to improve). Some topics are not addressed, possibly because Dalio has not gotten around to writing them down. He dismisses job-related stress, leaving it to employees to internalize egos or handle the frustration of being humbled by a jarring critique of a recently completed project.

The principles don't address the value and importance of diversity in organizations--except when Dalio explains the value of permitting all voices within an organization to speak up and share their views or criticism of others.

For the most part, the Bridgewater approach is "take it or leave it." But Dalio heartily believes you might be better off "taking it."

Would you be willing to do so?

Tracy Williams

The Quants: In Search of the "Truth"

The Quants, the new book by Wall Street Journal reporter Scott Patterson, comes amidst the barrage of books attempting to dissect the crisis. Patterson focuses partial blame on a cadre of hedge-fund managers, Ph.d. types who over the past two decades developed well-known quantitative-trading methods.

They happen also to frequent the same social circles, distract each other by playing each other in high-stakes poker matches, and grew up and learned quantitative finance from some of the same professors and mentors.

Patterson provides a soft argument that these groups of traders (mathematical and computer experts with degrees in finance, economics or even physics) helped contribute to the financial crisis. He doesn't, however, provide a detailed proof--the kind that they (the Quants themselves) would appreciate if presented with polished, mathematical logic.

So don't read this book if you wish to (a) learn as much as possible about quantitative trading methods, (b) understand the direct links between some well-known finance theory (efficient markets, Black-Scholes options models, etc.) actual market behavior and (c) tap into the trading models and secrets that helped many of them make whopping amounts of money before the crisis.

The book is not a how-to or a thorough analysis of how exquisite financial models went awry. But the book is not necessarily a waste of time.

It's more a dissection of the cast of characters who were significant trading participants during the market collapse in 2008-09. It's almost up to the reader to determine whether the "characters" contributed to the collapse, took advantage of the collapse, or were victims of their own forms of market trading, trading based not on gut hunches and hubris, but on models, theories and black boxes. Patterson refers often to the models' recurring search for the "truth" in how markets are supposed to behave.

Hence, Patterson summarizes a few of the theories behind the models without scaring off the non-MBA or non-Ph.d. reader. He pays more attention to the hedge-fund traders' emotional roller-coasters, their innate drive to get models to present the "truth" correctly, and their stubborn confidence and devotion to their black boxes. He also describes their boldness and courage to take risks, tack on leverage, and stick with their models even when markets tell them they might be wrong.

Among the countless hedge-fund managers and quant types on Wall Street or in Greenwich, Connecticut, Patterson focuses on a few: Notably, Peter Muller at Morgan Stanley, Ken Griffin at Citadel, Cliff Asness at AQR, and Boaz Weinstein at Deutsche Bank. He shows how they are connected in many ways. They meet up in the same Poker-playing circles. They had some of the same professors at University of Chicago. And they watch, study, and follow study each other and sometimes learn from others.

In the book, we see less about how Griffin at Citadel grew obnoxiously rich from trading convertible bonds, more about how he was a hot-tempered, demanding, sometimes near-abusive manager of a fund that went through a near meltdown during the crisis.

We see less about how Asness at AQR had been a master at statistical-arbitrage trading, more about how he suffered during the 2008 collapse, going through episodes of destroying desktop computers or isolating himself in his office trying to understand why markets didn't behave they way he said they should or would.

Thus, the book is more a summary of how primary players in hedge funds battled their way through the crisis. Years from now, the book won't stand out among the dozens of crisis tales recently published. It can be regarded as a chronicle of survival from the vantage point of a handful of highly regarded quants.

Tracy Williams

The Big Short: Sequel to Liar's Poker?

"The Big Short." The book by author Michael Lewis that has raced to the top of the New York Times best-selling list only a month after publication. The book many in finance are talking about over the last week. The book that has become a must-read after last week's Goldman Sachs allegations by the SEC--if only to understand better CDO's and CDS's tied to mortgage markets. Collateralized-debt obligations. Credit-default swaps linked to subprime loans.

Several weeks ago, when the financial press hinted at the new book, one had to wonder what else was there to say or write about regarding the financial crisis. What could possibly be Lewis' spin on the collapse of mortgage markets and the subprime debacle after a dozen or so books have already attempted to pontificate over what happened in 2006-08?

In his epilogue, he acknowledges he thought of doing a soft sequel to his best-selling book "Liar's Poker." That book chronicled his experiences as a junior bond trader at Salomon Brothers. It reached the top of best-selling lists, describing with candid humor the sometimes-vulgar, wealth-generating culture of trading bonds at a major investment firm. That book, at least among finance types, is regarded a classic. MBA students today, who were barely toddlers when it was published, still discuss it or put it on their summer reading lists.

This book, "The Book Short," is "Liar's Poker" with a 2010 twist. In the 1980's, Lewis was a player and participant. In 2010, Lewis is an outsider--older, distant, and more confident in his survey and assessment of what happened in the subprime debacle. Lewis' prior stint on Wall Street gives him an advantage to explain the daily pressures, grind and intoxication of profits in derivatives trading. He has authored many successful books (including "Blind Side" and "Moneyball"). This experience and special skill allow him to tell a polished story and keep his readers intrigued, no matter the subject--even if the subject is shorting markets via the credit-default swaps.

Lewis tells how a handful of traders and fund managers painstakingly made hundreds of millions by betting on the collapse of the subprime mortgage market. Did they have special insight? Did they do proper homework or analysis? Did it take a special, neurotic character to forecast doom? Or were they just plain lucky?

It was as if he picked up decades later where Liar's Poker ended and described a more advanced, more insane (to him) chapter in bond markets--CDO's and CDS's in subprime loans. Or get this: synthetic CDO's, based on counterparties taking different sides in a credit-default swap tied to subprime mezzanine bonds linked to subprime loans.

If that doesn't make sense immediately, then some second-year MBA finance courses can delineate it mathematically. Or you can read Lewis' book, a primer on CDO's and CDS--without the math, without the fragile, bewildering deal structures, and without the bell-shaped statistical curves. He describes CDO's as a multi-floor office tower, where the sludge was supposed to be in the basement--not on the middle and top floors (where it turned up). At his best, he describes the opaqueness and whims of the market, the day-to-day "marking to market," the collateral required to maintain positions, the ugly pricing disputes, the highly paid dealers, panicking investors, and the general empty feeling that nobody is overseeing it all.

If you want to understand thoroughly the Goldman Sachs Abacus transactions the SEC has targeted, read this book.

This sequel is not a reflection of a disenchanted twenty-something trader. It is the wisdom of an informed outsider who decided to take a peek at his old world. Sardonic, cynical, drawing humor from chaos. Lewis explores motivation by greed, but zooms in on most people's disregard of the possibility that the worst case can happen.

The actual story centers around three disillusioned investment groups who aspire to find a way to bet their convictions that the mortgage markets will collapse at some point in the future. Meanwhile, they watch their positions, suffer anxiety attacks, and fend off investors.

Lewis explains derivatives with parables and analogies and tries to show how personalities and behavior can move markets. He describes the market with a talent to amuse and make any CDS pricing dispute interesting.

With Goldman allegations under watch for the next several months, Lewis may need to add a chapter or two. He's doing so with regular appearances in the financial media to sell the book and to present the chapter he would have written.

Lewis says there will surface more CDO and CDS deals (subject to SEC investigation or presented to the public for similar scrutiny) that will get headlines or be subject to public backlash.

And he knows he'll need to add not one, but two or three more chapters in the book's inevitable second edition.

Tracy Williams