Compensating Financial Experts

• DOI: http://doi.org/10.1111/jofi.12372
• Published date: 01 December 2016
• Date: 01 December 2016
• Author: RICHARD LOWERY,VINCENT GLODE

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 6 •DECEMBER 2016

Compensating Financial Experts

VINCENT GLODE and RICHARD LOWERY∗

ABSTRACT

We propose a labor market model in which financial firms compete for a scarce supply

of workers who can be employed as either bankers or traders. While hiring bankers

helps create a surplus that can be split between a firm and its trading counterparties,

hiring traders helps the firm appropriate a greater share of that surplus away from

its counterparties. Firms bid defensively for workers bound to become traders, who

then earn more than bankers. As counterparties employ more traders, the benefit of

employing bankers decreases. The model sheds light on the historical evolution of

compensation in finance.

COMPENSATION IN THE FINANCIAL sector has been a controversial topic in recent

years. One particular group of workers who tend to earn extraordinary rewards

for their expertise are traders in over-the-counter (OTC) markets. For instance,

before the recent crisis, managing directors trading exotic credit derivatives

earned on average $3.4 million per year.1More recently, average salaries paid

to various types of traders (e.g., commodities, securitized-products) grew by

10% in 2014 alone.2

∗Vincent Glode is from the Wharton School, University of Pennsylvania. Richard Lowery is from

the McCombs School of Business, University of Texasat Austin. We are extremely thankful to Mike

Karp and Jessica Lee from Options Group for sharing their statistics on Wall Street compensa-

tion and for discussing the ideas in the paper. We also thank Bruno Biais (Editor), an Associate

Editor, two referees, Franklin Allen, Fernando Anjos, Jonathan Berk, Andres Donangelo, Mike

Fishman, Xavier Gabaix, Itay Goldstein, Joao Gomes, Rick Green, Mark Jenkins, Rich Kihlstrom,

YaronLeitner, Doron Levit, Hamid Mehran, Christian Opp, Guillaume Plantin, Andy Postlewaite,

Ned Prescott, Uday Rajan, Michael Roberts, Andrei Shleifer, Raj Singh, Andy Skrzypacz, Rob

Stambaugh, Mathieu Taschereau-Dumouchel, Luke Taylor, Ed Van Wesep, Vish Viswanathan,

Alexander Wagner, Jun Yang, and seminar participants at Boston College, Dartmouth, Harvard,

HEC Paris, Rice, Rochester, Stanford, UT–Austin, UT–Dallas, Wharton, the 2013 Duke–UNC

Corporate Finance conference, the 2012 FIRS meeting, the 2012 Georgia State conference on In-

stitutional Investors, the 2013 SFS Cavalcade, the 2014 Texas Finance Festival, the 2012 UBC

Summer Finance conference, the 2013 Wash-U Corporate Finance conference, and the 2013 WFA

meeting for helpful comments and discussions. Deeksha Gupta, Michael Lee, and S´

ebastien Plante

provided excellent research assistance. The paper previously circulated under the title “Informed

Trading and High Compensation in Finance.” Glode acknowledges financial support from the Cyn-

thia and Bennett Golub Endowed Faculty Scholar award. The authors declare that they have no

relevant or material financial interests that relate to the research described in this paper.

1See “London trader bonuses top those in U.S.—survey” published March 26, 2007, on

Reuters.com.

2See “Traders’ salaries climb 10 percent in 2014” by John D’Antona Jr.in the August 2014 issue

of Traders Magazine.

DOI: 10.1111/jofi.12372

2781

2782 The Journal of Finance R

In this paper, we propose a labor market model that highlights the impor-

tance for financial firms of hiring highly talented individuals as OTC traders

by offering them seemingly excessive levels of pay. We assume that financial

firms compete to hire a scarce supply of skilled workers who can be employed

as either bankers or traders. A banker helps his employer identify profitable

investment opportunities, while a trader helps his employer value securities

backed by the investments of other firms, in case these firms need to trade

the securities for liquidity reasons. Thus, deploying workers to banking raises

the surplus that can be split between a firm and its trading counterparties,

whereas deploying workers to trading allows the firm to appropriate a larger

share of that surplus.

High compensation for traders arises in our model despite the presence of

two factors usually presumed to mitigate it. First, we assume that the employ-

ment of traders is concentrated among a few firms, consistent with evidence

of concentrated trading in derivative markets by Cetorelli et al. (2007), Atke-

son, Eisfeldt, and Weill (2013), and Begenau, Piazzesi, and Schneider (2013).

Second, we assume that traders are hired only to strengthen their employers’

position when bargaining with other firms over a fixed pie (hence creating no

social value), consistent with Wall Street insiders describing quantitative trad-

ing as “us against them” and “sharks devouring one another” (Patterson (2012,

p. 17 and 181)). Our model highlights how these factors might have actually

caused rather than mitigated the high levels of compensation observed in the

financial sector.

Since a trader’s expertise improves his employer’s ability to appropriate the

surplus in a zero-sum trading game, hiring traders imposes something akin to

a negative externality on future trading counterparties (in the sense that the

private benefit of such action exceeds its social benefit). This leads to defensive

bidding by firms that offer traders what we call a “defense premium” above their

internal marginal product. Without such a premium, the traders a firm targets

would be hired by rival firms (i.e., potential trading counterparties) and their

expertise would be used against the firm in question. Notable, albeit extreme,

examples of traders whose hiring was detrimental to rival firms include Josh

Levine, who pioneered high-frequency trading in the early 1990s and allowed

the proprietary trading firm Datek to “out-trade the very best in the business.

They could grind Goldman to a pulp. They could make Morgan cry,” or algo-

rithmic trader Haim Bodek, whom UBS poached from Goldman Sachs in the

early 2000s “to build an options-trading desk that could go head-to-head with

the likes of Hull [Goldman’s electronic trading arm]” (Patterson (2012, p. 100

and 32, respectively)).

Workers deployed as bankers, however, do not earn as much as traders.

When hit by liquidity shocks, firms need to sell the profitable investments

their bankers have identified, sometimes at a discount, allowing their counter-

parties to appropriate part of the surplus these bankers helped create. As a

result, hiring bankers is similar to providing a public good and bankers earn

less than traders. Furthermore, as the number of traders employed by trading

counterparties increases, the benefit of employing bankers decreases, resulting