Proving sociologists right: pencil pushers and Neardenthals stave off the next crisis by uniting on the trading floor

February 24, 2010

From the early debates between Adam Smith and Karl Marx, the benefits and dangers of a formal organizational structure have been of central interests to sociologists. A recent article on the Financial Times comments on an intriguing trend within London’s financial City that brings this problem to the fore. Banks appear to be merging the trading desks that specialize in trading different assets. Specifically, the FT comments on the practice of Derek Bandeen, a senior equities trader at Citi:

[Bandeen] has merged Citi’s cash equities and derivatives trading desks – a sea change for a business that had segregated the two for years. (…) “There is no way you can be a cash [equities] trader and not know what’s going on in the derivatives market. You’ll just be run over, again and again,” Mr Bandeen says. Bringing them together to create a trading environment that is more “multi-asset class”, in the industry jargon, is a trend that has been sweeping the trading rooms of London, driven by rapid advances in electronic trading.

The trend to merge desks is widespread among American banks, and beginning to take hold in European banks too. It is driven by the rise of trading strategies –arbitrage– that have led different securities to trade more in unison. “Today,” the journalist writes, “different types of asset can be traded against each other more effectively than through the more cumbersome telephone or floor broking methods of the old days. So one type of financial instrument, such as a share, is often affected by the behaviour of another, such as an option on that share.”

The problem, of course, is that such cooperation is limited by cultural differences across trading desks. According to Bandeen (cited in the article),

The typical stereotype is that equities traders think the derivatives guys are a bunch of pencil-pushing geeks who don’t understand stocks while the derivatives guys think the equities guys are a bunch of Neanderthals (…) The trick is bringing them together.

This sudden recognition of the importance of structure is a critical development for sociologists of finance. Since 2004, sociologists like myself and David Stark have been arguing that banks can exploit arbitrage opportunities by promoting communication across different trading strategies. As we explained in “Tools of the Trade,” in the specific trading room that we studied the manager had created a detailed set of management policies to integrate the different desks… against an incentive system that pushed people to the opposite. He was successful, and the numbers at the bank proved him right.

Post-crisis, the story has become a much higher stakes game. In his influential study of the credit crisis, Donald MacKenzie has argued that this cultural divide is precisely the reason for the credit crisis. Journalist Gillian Tett has made a similar argument. As MacKenzie wrote in his review of Gillian Tett’s Fool’s Gold,

The previously largely distinct worlds of CDOs and of mortgage-backed securities became increasingly linked from 2002 on. It was an encounter of two subtly different cultures, with for example quite different mathematical approaches. (…) The CDO world developed explicit and increasingly elaborate models of correlation (…) while the mortgage world handled the phenomenon entirely implicitly. In most investment banks, and also – as far as I have been able to discover – in the New York head offices of the rating agencies, separate departments handled mortgage-backed securities and CDOs based on corporate debt. In the investment banks, for instance, those different departments seem to have had surprisingly little to do with each other. The two cultures never really merged; instead, the CDO, a structure invented by the corporate-debt world, was applied to the products of the mortgage world. Members of both cultures now see the encounter as corrupting. ‘They’ – constructors of CDOs based on mortgage-backed securities – ‘took our tools’ and misused them.

The implications of the argument are key. Organization theory can be the next key tool in acquiring a trading edge and limit risk. If this is the case, we should expect banks to take a sudden and renewed interest in departmentalization, institutionalization, social networks, etc. And indeed, my current employer (the London School of Economics) may start offering a course in the sociology of finance to master students in management. A conference on the sociology of finance for hedge fund managers is coming up in June. One wonders what this might all lead to…

6 Responses to “Proving sociologists right: pencil pushers and Neardenthals stave off the next crisis by uniting on the trading floor”

  1. Will Davies Says:

    Don’t economists already have their own tools for addressing this issue, namely transaction cost economics (or industrial organisation economics)? The fact that different forms of organisational structure possess different forms of competitive advantage in different markets is there in Coase and then Williamson.

    Not being an economist, I don’t know how much people have applied this approach to financial institutions. I can see that it may be under-developed in that context, as financial institutions have unusually high faith in the price mechanism – social capital, hierachy and trust have less credibility than prices as mechanisms for coordination (hence why bonuses got so big and culture gets so poisonous: employees want every ounce of the employment relationship to be represented in $$, not in social externalities). So maybe now is the time to think more carefully about HR in this context. But this doesn’t point towards a sociological perspective, in my view, although it depends how broadly you define sociology (I had never considered Coase or Williamson to be sociologists).

  2. danielbeunza Says:

    Will — your rejoinder made me think hard; thank you. At the broadest level, economists have made the point that organization matters. But the reasons they provide are irrelevant to this discussion.

    Coase’s argument is about the firm vs the market; the issue here is about different ways to structure a firm… a trading room.

    Williamson’s argument (M versus U forms) is based on technological interdependencies in manufacturing firms (not even transaction costs); my point, by contrast, is based on cognitive interdependence and the complexities of using financial models. And economists could never get these two because (1) as Brian Arthur says, economists don’t study cognition; and (2) the irrationality-rationality debate prevents them from seeing models as an imperfect but acceptable tool — it’s four legs good, two legs bad.

    So is departmentalization part of sociology? The folks that talked about this are Marx, in his critique of the division of labor; Lawrence and Lorsh in their study of contingency theory; and then everyone who has written about the flat organization — David Stark, Woody Powell, etc. It is as sociological as it gets.

    Who should care about it? The mistake, I think, is to think that this is a HR issue. That’s what my MBA students used to think… softie stuff, we don’t care, let me cut class and do a job interview at Goldman.

    It is precisely the opposite of it. It is a top management issue, because it deals with HR, trading strategy, office design and risk management. And because it led banks down the path of a crisis.

  3. joseossandon Says:

    I think the Mackenzie paper you mention is really great, not just because it shows how cultural frames are not just present but produced in(by) finance, but because it goes further suggesting these cultural merges create new uncertainty. As far as I understood it, it is not just that his case was an unsuccessful fusion, but that merging different cultures open unforeseen issues that could even help in explaining such a crisis! Perhaps, what this paper is doing is complementing other classics such as DiMaggio&Powell and so on, and in this sense, rather than opening new tools to limit risk, stressing the always present tension between managing risk / and creating uncertainty in organizations.

  4. danielbeunza Says:

    Right on. Donald’s cultural hypothesis definitely deserves deep consideration. My students have been grappling with it for a few weeks now.

    Another very interesting example of a merger gone wrong, leading to crisis, is the case of Barings Bank and the antics of Nick Leeson. As the Barings Case shows (the business case written by IMD faculty Stewart Hamilton and Donald Marchand), the root of the problem was in cultural misunderstandings between the two halves of a merger… the original Barings Bank (elite), and Henderson Crosthwaite (free wheeling, innovative, with foothold in Asia). Leeson was able to exploit the differences between the two.

  5. tom brakke Says:

    As an investment person who specializes in looking at how decisions are made, I can tell you that there are vast opportunities to apply these principles to good effect at investment firms.

    I did a piece today about dealing with these examples of structured myopia. Thanks for the inspiration.

  6. Keith Piccirillo Says:

    I just googled “Do Sociologists make good traders” and landed here.
    I did my last paper decades ago at university on “cultural lag”.
    Material culture can sometimes outpace non-material culture and we can get a linguistic lag through misleading communication streams, e.g., the current oil leak triumvirate of BP, RIG, and HAL.

    At many levels of industry, workers have been forced to take on too many responsibilities and although they have a greater diversity in skills, dotting of I’s and crossing of T’s doesn’t always happen.

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