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Q&A With Nicholas Dunbar, Author of "The Devil's Derivatives"

Dunbar explains the nature of risk taking at trading firms, how Jon Corzine embodied that culture, and why the threat of major losses generally keeps investors from making risky bets.

How are risk management operations supposed to function at a broker dealer? Aren't they not supposed to take on any inherent risk based on their business model?

Dunbar: Well, that's right and it's a tough question that regulators are grappling with because they need to be able to do things like market making of securities. They need to be able to do underwriting of securities. There are things where they have a function and that can involve taking on risks for short periods of time. So an underwriter may very well have a book of bonds, or while they're doing a new issue a market maker might need to warehouse a position while it matches up two sides of a trade.

It's not new that broker-dealers do take on risks in doing the usual role. However the challenge is when they start doing proprietary trading, when they start to make their own bets on the market and that's not caught by their own risk management or their own mechanisms.

This is essentially what happened at MF Global, correct?

Dunbar: Exactly. So here you have a company that most of its customers saw as a futures broker or a broker that was hooking them up with exchanges, helping them execute transactions, taking some margin and facilitating their business. That's what most people thought MF Global was doing.

And they hired Jon Corzine, a former Goldman trader - obviously all those years in New Jersey didn't take it out of his system. He kind of went back to what he thought he knew how to do which is to make bets and that's what he did. But the people that ran MF Global, the board of the company, the shareholders, didn't really have a grip on this risk taker that they hired.

Is this fiasco a symptom of a larger problem - maybe attitudes towards risk management haven't changed as much as we though they did in the aftermath of the financial crisis?

Dunbar: It's an interesting question because if you look at what's going on in Europe, there's a huge change in risk taking. There's massive risk aversion. A lot of investors are pulling out of countries like Italy or Spain and they're being incredibly risk averse. They're not even lending to apparently safe banks in these countries. So we're going through a period of intense risk aversion. However what you have is within some broker-dealer firms or trading companies, a culture of people that think they can match their risks. They can hedge themselves and they feel comfortable about making bets. This is what I write about in my book.

In the book I divide the world into two kinds of people: the people who hate to lose and the people who love to win. Most of us hate to lose, we don't like uncertainty, we try to avoid it. We avoid bets with a big downside compared to the upside. And that characterizes most financial institutions. It characterizes most companies: pension funds, insurers. That's pretty much the way normal people think and operate.

But inside trading firms, you need to have more of a confidence about taking risks. So people get insulated and conditioned into feeling that they can be hedged. They put up margin; they put up cushion against loss. And on the other side they're willing to put everything onto a bet that can give them a good payoff. And that's a culture that has been created on Wall Street over many years. Jon Corzine typifies that culture.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio

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