Books, Corporate Life, Quantitative Finance

Validation and Processing

Once a trade is booked into the trading platform database, it triggers a whole chorus of validation and daily processing. The validation process is a to-and-fro dance between the trading desks in Front Office and the control units in Middle Office, all mediated by the trading platform. The traders may insert a trade on an experimental basis. Once they are convinced that it is a viable trade, they push it to a confirmed state, which will be picked up by the treasury control unit. If the traders decide to discard the trade, the trade ends up in the trash pile (but never deleted permanently). The control unit typically works in a four-eye, double validation mode. They verify the trade inputs, and control limits such as the number of trades allowed for a particular product. If the trade passes their tests, they set its status to a validated state, which triggers a second level of checking. If the trade fails either level, they are pushed back into a state that allows the traders to either amend it or discard it.

Trade validation

Once the trade is fully validated, the processing part begins. It involves multiple teams and multiple perspectives, starting from how a trade should be identified to what the basic information unit that should be identified.

Daily Processing

As shown in the figure above, regular processing takes place in various business units.

  • Trading Desks monitor trades for hedging and rebalancing, monitoring profit and loss (P/L), and staying within the risk limits. The senior traders get distilled information from the junior ones through this regular processing and take appropriate actions.
  • Middle Office plays a crucial role in regular process. They monitor target and barrier breaches, rate fixings and option exercises, cash flow generation, and spawning other cash trades. They generate (with the help of the trading platform) appropriate accounting triggers for Back Office to act on, in order to perform settlements, trade confirmation, documentation archival etc.
  • Product Control is another business unit embedded within the middle office that actively monitor the P/L on a daily basis, with a view to explaining their movements based on the sensitivities and market movements, providing an independent computation of the profitability of the trading activity. Their computations of reserves feed into the finance and human resources departments and affect trader incentives and compensation.
  • Market Risk Management also has hordes of staff employed to perform daily monitoring of trading limits (such as notionals, delta-equivalents etc.) as well as VaR computation, Stress VaR tests. In most banks, they also handle compliance reporting to regulatory authorities and provide concise and actionable intelligence to the upper management who decide the trading strategies.

As we shall soon see, the different and specific focus of each business unit demands a unique projection (which we will call a perspective) of the trading information from the trading platform. This requirement is one of the things that make its design and implementation so challenging.

Life and Death, Philosophy, Physics

Why Do We Drink?

We get in trouble or at least embarrass ourselves once in a while because of our drinking. Why do we still do it? Ok, it is fun to have a drink or two at a party — it gives you a buzz, loosens your tongue, breaks the ice etc. But most of us go way beyond that. We almost always end up regretting it the next morning. But we still do it.

Alcohol actually tastes bad, and we have to add all kinds of sodas and fruit juices to mask it. It is a depressant, so if we drink it when we are sad, it makes us sadder. It is toxic to our liver, kills our brain cells and makes us do silly things like puke and generally make an ass of ourselves. But, by and large, most people who can get their hands on it, drink it.

I am not talking about alcoholics who have trouble controlling their urges (although I believe most of us are budding alcoholics). I am not even talking about why we start drinking — that could be because of peer pressure, teenage dares, curiosity etc. I’m talking about those of us who continue drinking long after that sweet buzz that alcohol used to give us is history.

I do have a theory why we drink. But I have to warn you — my theory is a bit looney, even by the generous standards of this Unreal Blog. I think we drink because it alters our sense of reality. You see, although we don’t usually articulate it or even consciously know it, we feel that there is something wrong with the physical reality we find ourselves in. It is like a tenuous veil surrounding us that disappears the moment we look at it, but undulates beyond the periphery of our vision giving us fleeing glimpses of its existence in our unguarded moments. Perhaps, if we can let our guard down, may be we can catch it. This vain and unconscious hope is probably behind our doomed attractions toward alcohol and other hallucinants.

Although the veil of reality is tenuous, its grip on us is anything but. Its laws dictate our every movement and action, and literally pull us down and keep us grounded. I think our minds, unwilling to be subjugated to any physical laws, rebel against them. Could this be behind our teenagers’ infatuation with Stephenie Meyer’s vampire stories and Harry Potter’s magic? Isn’t this why we love our superheroes from our childhood days? Do we not actually feel a bit liberated when Neo (The One in Matrix) shows that physical rules don’t apply to him? Why do you think what we worship are the miracles and the supernatural?

Well, may be I am just trying to find philosophical reasons to get sozzled. Honestly, I’m feeling a bit thirsty.

Corporate Life

Capitalism vs. Corporatism

During a recent conversation with him, this client of mine used the word “corporatist” to describe his country (US of A). He said twenty years ago, they were a capitalist country, not a corporatist one. Now, this is a kind of fine distinction that I’d love to talk about. To me, it was a surprising and illuminating distinction, one that cleanly dissects and clears up the economic confusion of our times. And I had to write about it.

Everybody knows what capitalism is. It is the market-driven, private-ownership-centric economic system where selfish motives bring about collective happiness, according to Adam Smith. This way of life has been accepted as the “good” system, and stands in stark contrast with the collective, community-owned economic system with notions of robust social redistribution of wealth — communism or socialism. Although the latter does sound like a better and more moral ideal, at least in principle, it never did pan out that way.

Corporatism is not as well-known as capitalism. At least, I didn’t know that such a word existed. But the moment I heard it, I could guess what it meant. It points to the end product of unbridled capitalism, one with no government control, or even moral hangups. In my view, it happens this way — once you have private ownership, some people get richer than the rest. There is nothing wrong with that; in fact, it is a mathematical certainty. But then, money gives those lucky guys more power, and access to ways in which they can make more money. For instance, they can influence the political system, and through it the fiscal and taxation policies. Also, private ownerships can be pooled together to form economic organisms that can sustain themselves. These organisms are, of course, corporate bodies. They exert power through their collective wealth to an even greater extent than the good old capitalists.

A curious thing happens when capitalists (simple rich folks, that is) get sidelined by corporations. The money and power get separated in a strange way. The board members and CEOs who control the corporate bodies end up wielding power, instead of the owners. They are entrusted with the task of guarding and growing the capital. They find novel strategies to do this, like taking advantage of tax loopholes and tax havens, and engaging in unsavory business practices (like mixing any damn white powder with baby food, for instance). As long as they succeed in their remit of growing the capital, they seem to absolve themselves of the moral implications of their actions. For their services, they pay themselves handsome rewards. Note that the corporatists (the operators) pay themselves; it is not as though the capitalists (the owners) pay them, wherein lies the separation of power and money.

When you bring in the financial system whose primary function is capital management, the separation of power, money and morality takes on a new dimension. So banks, with no intrinsic economic value of their own, turn out to be too big to fail, and the system rearranges itself in such way that even when they do fail, it is the people farthest removed from power and money are the ones who pay for it. The high-flying bankers and senior managers get golden parachutes because they have both power and money. The trickle-down economy envisioned in pure capitalism (an optimistic vision to begin with) only trickles through channels drawn by the corporate overlords.

These unfair trickles did not bother us (the middle class) for a long time because they were not all trickling away from us. Now that they have started to, we are beginning to sit up and protest. I sympathize with my American client. Now that the corporatists are after our little trickles, we hate corporatism.

Humor

Chinese Names

As you may know, a San Francisco TV channel got in trouble for reporting fake names of the pilots involved in a recent air crash. If you missed it, here is the video — the fake names are around the 43rd second mark.

http://youtu.be/wFA7t1sHxBI

In light of this TV report, I thought I would post a bunch of fake names that I got through email a while ago. It definitely seems timely, if not appropriate.

That’s not right Sum Ting Wong
Are you harboring a fugitive? Hu Yu Hai Ding
See me ASAP Kum Hia Nao
Stupid Man Dum Fuk
Small Horse Tai Ni Po Ni
Did you go to the beach? Wai Yu So Tan
I bumped into a coffee table Ai Bang Mai Fu Kin Ni
I think you need a face lift Chin Tu Fat
It’s very dark in here Wai So Dim
I thought you were on a diet Wai Yu Mun Ching
This is a tow away zone No Pah King
Our meeting is scheduled for next week Wai Yu Kum Nao
Staying out of sight Lei Ying Lo
He’s cleaning his automobile Wa Shing Ka
Your body odor is offensive Yu Stin Ki Pu
Great Fa Kin Su Pa

Apologies if you find this post offensive — only trying to be funny here.

Life and Death, Topical

Why did Federer Lose?

I am a Federer fan. His inevitable decline has been a source of grief for me. When it comes to shot selection, imagination and pure magical talent, there isn’t another tennis player who could ever hold a candle to him. Why did he have to go and lose in the second round of Wimbledon? It damn near broke my heart.

Roger FedererOk, we all know the answer. He is getting too old. But he is only 31, and has to be in terrific shape. I am pushing fifty and can still put in a couple of hours of vigorous badminton. Sure, weekend badminton is no world class tennis, and the effects of aging are very different. Still…, I wish he would stick around a bit longer.

A few months ago, I listened to a series of interesting lectures on the effects of aging on our perception and sensory processes. One thing new that I learned there was that we all have a sixth sense, in addition to sight, hearing, touch, taste and smell. It is the kinesthetic, muscle feedback, which is the sense that allows you to apply just the right amount of pressure, for instance, when braking your car, or holding a baby. You may lose this sense when you get angry and break the glass you are holding, if we are to believe Hollywood movies. In certain games, this sense can make an enormous difference. I had a friend who was a pool shark. He once told me that at the top of his game, he could feel the tiny nicks and scratches on the cue ball through the cue stick in his hand. When I knew him, he was well past his prime, but he could still call shots like bank off the point of the side pocket, and double kiss into the corner pocket. And make them. So I believe him and Eddie Felson (The Hustler) when he says the cue stick, when he holds it, has nerves. I bet Federer could feel the seams of the tennis ball and the amount of spin he was putting on them through the strings and the grip of his racket.

Age blunts the sharpness of all of your senses. The most obvious is your sight. In your forties, you have to hold your smart phone farther and farther away from your face to read the tiny screen. At some point, your hand is not long enough and you end up using reading glasses — reluctantly at first, but more readily as the years roll by and the images get blurrier. Apparently you lose your sensitivity to high pitched sound as well. So teenagers can download ringtones that their parents and teachers are deaf to. But the first sense to go is the muscle feedback, which begins to decline in your teens. This, apparently, is the reason why the Olympic gymnasts are all teenagers. By the time they are in their twenties, this sense of theirs is already too weak to keep them competitive at that level. I guess it is this sense that has deserted Roger Federer as well.

Frederer’s brand of tennis with its finesse and artistry demanded more of this sense. His opponents tend to hit flatter and harder. I read somewhere that they use stiffer rackets for this purpose, and can hold Federer behind the baseline. The champion stubbornly refuses to switch to this style and this kind of rackets. May be he is getting a bit too old. Reminds me of Bjorn Borg, when he attempted a mini come-back with his wooden racket.

Books, Corporate Life, Quantitative Finance

Trade Inception

The inception events of a trade can be classified into two categories. The pre-trade activities are those that have to take place even before the first trade is booked. The per-trade inception activities are the ones specific to each trade.

Pre-trade activities

The pre-trade activities are related to new product on-boarding and approval. As we saw, in-house trading platforms are designed to be nimble and responsive. In principle, it should take little time for a new product to be on-boarded. The last system I worked on, for instance, was designed to deploy a new product idea in a matter of minutes. But the architects of such systems tend to forget the human, process-related and control elements involved in it. As the slide above illustrates, a new product idea or a new pricing model originates from the work of a model quant or a structurer in Front Office. But before it gets anywhere near a production system, the pricing model needs to be validated, typically by the analytics team in the Middle Office risk management group. Once validated, the product goes through a tortuous approval process that may take weeks or months, and then a formal deployment process, which may again take weeks or months. When that process is completed, the product is available for trading in the trading platform.

Once available, the product can be instantiated as a trade. Each trade instance goes through its own validation and approval process. The trade request may originate from the sales or structuring team in Front Office. They will also prepare the term sheet and other legal documents. Once these tasks are completed, a trade is booked into the trading platform.

Per-trade process

These inception events are depicted in the second slide above. One of the crucial steps in the approval process is the credit control. As we described earlier, the credit risk management team uses a variety of tools to assess the risks involved. With their approval, and with the traders understanding of the market price of the product, a product available in the trading platform becomes a trade in the database. And the lifecycling fun begins.

Humor, Parenting, Philosophy, Physics, Work and Life

Deferred Satisfaction

The mother was getting annoyed that her teenaged son was wasting time watching TV.
“Son, don’t waste your time watching TV. You should be studying,” she advised.
“Why?” quipped the son, as teenagers usually do.
“Well, if you study hard, you will get good grades.”
“Yeah, so?”
“Then, you can get into a good school.”
“Why should I?”
“That way, you can hope to get a good job.”
“Why? What do I want with a good job?”
“Well, you can make a lot of money that way.”
“Why do I want money?”
“If you have enough money, you can sit back and relax. Watch TV whenever you want to.”
“Well, I’m doing it right now!”

What the mother is advocating, of course, is the wise principle of deferred satisfaction. It doesn’t matter if you have to do something slightly unpleasant now, as long as you get rewarded for it later in life. This principle is so much a part of our moral fabric that we take it for granted, never questioning its wisdom. Because of our trust in it, we obediently take bitter medicines when we fall sick, knowing that we will feel better later on. We silently submit ourselves to jabs, root-canals, colonoscopies and other atrocities done to our persons because we have learned to tolerate unpleasantnesses in anticipation of future rewards. We even work like a dog at jobs so loathesome that they really have to pay us a pretty penny to stick it out.

Before I discredit myself, let me make it very clear that I do believe in the wisdom of deferred satisfaction. I just want to take a closer look because my belief, or the belief of seven billion people for that matter, is still no proof of the logical rightness of any principle.

The way we lead our lives these days is based on what they call hedonism. I know that the word has a negative connotation, but that is not the sense in which I am using it here. Hedonism is the principle that any decision we take in life is based on how much pain and pleasure it is going to create. If there is an excess of pleasure over pain, then it is the right decision. Although we are not considering it, the case where the recipients of the pain and pleasure are distinct individuals, nobility or selfishness is involved in the decision. So the aim of a good life is to maximize this excess of pleasure over pain. Viewed in this context, the principle of delayed satisfaction makes sense — it is one good strategy to maximize the excess.

But we have to be careful about how much to delay the satisfaction. Clearly, if we wait for too long, all the satisfaction credit we accumulate will go wasted because we may die before we have a chance to draw upon it. This realization may be behind the mantra “live in the present moment.”

Where hedonism falls short is in the fact that it fails to consider the quality of the pleasure. That is where it gets its bad connotation from. For instance, a ponzi scheme master like Madoff probably made the right decisions because they enjoyed long periods of luxurious opulence at the cost of a relatively short durations of pain in prison.

What is needed, perhaps, is another measure of the rightness of our choices. I think it is in the intrinsic quality of the choice itself. We do something because we know that it is good.

I am, of course, touching upon the vast branch of philosophy they call ethics. It is not possible to summarize it in a couple of blog posts. Nor am I qualified enough to do so. Michael Sandel, on the other hand, is eminently qualified, and you should check out his online course Justice: What is the Right Thing to Do? if interested. I just want to share my thought that there is something like the intrinsic quality of a way of life, or of choices and decisions. We all know it because it comes before our intellectual analysis. We do the right thing not so much because it gives us an excess of pleasure over pain, but we know what the right thing is and have an innate need to do it.

That, at least, is the theory. But, of late, I’m beginning to wonder whether the whole right-wrong, good-evil distinction is an elaborate ruse to keep some simple-minded folks in check, while the smarter ones keep enjoying totally hedonistic (using it with all the pejorative connotation now) pleasures of life. Why should I be good while the rest of them seem to be reveling in wall-to-wall fun? Is it my decaying internal quality talking, or am I just getting a bit smarter? I think what is confusing me, and probably you as well, is the small distance between pleasure and happiness. Doing the right thing results in happiness. Eating a good lunch results in pleasure. When Richard Feynman wrote about The Pleasure of Finding Things Out, he was probably talking about happiness. When I read that book, what I’m experiencing is probably closer to mere pleasure. Watching TV is probably pleasure. Writing this post, on the other hand, is probably closer to happiness. At least, I hope so.

To come back my little story above, what could the mother say to her TV-watching son to impress upon him the wisdom of deferred satisfaction? Well, just about the only thing I can think of is the argument from hedonism saying that if the son wastes his time now watching TV, there is a very real possibility that he may not be able to afford a TV later on in life. Perhaps intrinsically good parents won’t let their children grow up into a TV-less adulthood. I suspect I would, because I believe in the intrinsic goodness of taking responsibility for one’s actions and consequences. Does that make me a bad parent? Is it the right thing to do? Need we ask anyone to tell us these things?

Books, Corporate Life, Quantitative Finance

Life of a Trade

With the last post, we have reached the end of the second section on the static structure of the bank involved in trading activities. But a trade by itself is a dynamic entity. In this third section, we will look at the evolution of a trade, and see how it flows back and forth between the various business units we described in the last section. We will make the this section and the next into a new series of posts because the first series (on How Does a Bank Work?) has become a bit too long.

Back Office and Finance

As with most dynamic entities, trades also have the three lifecycle stages of inception, existence and termination. What we need to understand clearly is what the processes are around these general stages. What are the business units involved at each of these stages? What do they do? And how do they do it?

Trade lifecycle

We will see that from our perspective, the lifecycle interactions are all mediated by the trading platform. It is not so much because everything is contained within the trading platform, but because we are interested only in that limited set of processes that are. In some sense, the last section was about the physical, spatial description of the bank, and this section is going to be on the temporal evolution and dynamics of how things work on that structure.

French, Humor, Malayalam

Languages

Before leaving India in the late eighties, I could speak a bit of Hindi as my third language. English was the second language, and Malayalam my mother tongue. I wasn’t fluent in Hindi by any stretch of imagination, but I could speak it well enough to get rid of a door-to-door salesman, for instance.

This is exactly what my father (a confirmed Hindi-phobe) asked me to do during one of my visits home when a persistent, Hindi-speaking sari salesman was hovering over our front porch. By that time, I had spent over six years in the US (and considered my English very good) and a couple of years in France (enough to know that “very good English” was no big deal). So to get rid of the sari-wala, I started to talk to him in Hindi, and the strangest thing happened — it was all French that was coming out. Not my mother tongue, not my second or third language, but French! In short, there was very confused sari salesman roaming the streets that day.

True, there is some similarity between Hindi and French, for instance, in the sounds of interrogative words, and the silly masculine-feminine genders of neutral objects. But I don’t think that was what was causing the outpouring of Frenchness. It felt as though French had replaced Hindi in my brain. Whatever brain cells of mine that were wired up to speak Hindi (badly, I might add) were being rewired a la franciaise! Some strange resource allocation mechanism was recycling my brain cells without my knowledge or consent. I think this French invasion in my brain continued unabated and assimilated a chunk of my English cells as well. The end result was that my English got all messed up, and my French never got good enough. I do feel a bit sorry for my confused brain cells. Karma, I guess — I shouldn’t have confused the sari salesman.

Though spoken in jest, I think what I said is true — the languages that you speak occupy distinct sections of your brain. A friend of mine is a French-American girl from the graduate years. She has no discernable accent in her Americanese. Once she visited me in France, and I found that whenever she used an English word while speaking French, she had a distinct French accent. It was as though the English words came out of the French section of her brain.

Of course, languages can be a tool in the hands of the creative. My officemate in France was a smart English chap who steadfastly refused to learn any French at all, and actively resisted any signs of French assimilation. He never uttered a French word if he could help it. But then, one summer, two English interns showed up. My officemate was asked to mentor them. When these two girls came to our office to meet him, this guy suddenly turned bilingual and started saying something like, “Ce qu’on fait ici.. Oh, sorry, I forgot that you didn’t speak French!”

Books, Corporate Life, Quantitative Finance

Summary – Structure of a Bank

We have now completed our discussion on the general structure of a typical investment bank trading arm. We went through the Front-Middle-Back Office divisions and the functional and business units contained within. Note that we looked only at those units that have a bearing on trading and quantitative development activities. Note also that this structure is fluid and may be implemented with different names and hierarchies in different banks depending on their corporate strategies and focus. We presented the trading platform as the enabler or backdrop of most of these activities of the global treasury (where exotics trading activities take place) and the associated business units (that handle various aspects of the trade workflow) mainly because we are looking at the whole thing from the quantitative development perspective.

Back Office and Finance

From this perspective, you see the trading platform as the most important tool (or collection of tools) in the bank. It mediates almost all the interactions among the various business units. Furthermore, as we shall see in future posts, the trading platform defines the trade workflow and lifecycle management. Therefore, it will also become important for the quantitative developers to understand how these business units view trades and the trade booking and management process. Their trade perspectives will have to influence the design of the trading platform.