Market maker bonuses under fire of the financial authorities – in effect over results over 2010. Bonus capped, stretched over three years and partly in non-cash items such as shares.

After several rounds of nice chit chat and popcorn moments reading the Quote 500 list and the who’s earning/losing what amount in which currency discussions – here’s a serious topic again. Everybody will remember the trouble with the housing bubble related financing stuff which have brought down scores of banks. Broad subject, in depth analysis elsewhere.

The thing is the Dutch national bank (DNB) and other European regulators intends to solve the perceived problem of bankers taking too much risk in search for a higher bonus reward. Betting the firm by bankers for a bigger boat with Christmas is called the moral hazard – and politicians and regulators will try to curb this behaviour.

Back to our plain vanilla, low leverage, listed option market making business. The DNB intentions can be found on their boring website, and the market makers weren’t really warned for the third document (pdf – Dutch). It basically says all measures for limiting speculation by bankers and hedge funds apply to all firms with a cash market maker license as well. Heard through the grapevine ; the market makers were surprised to read this, and had just one week to file their objections.

It isn’t a long term story beyond your horizon though- the new regulations will come into effect January 1st, 2011. That’s pretty soon. And here comes the part which may catch your attention if you’re expecting a bonus for trading in 2010 : bonuses for your trading result will already feel the pain from the new regulation. This new guidelines will even overrule your current contract with your employer. Paying a smaller bonus, would sound like a dream for some management teams – but their own bonuses will be harmed as well. Furthermore, it also says the shares of the company should be given as bonus to the traders.

The highlights of the proposed regulation:

  • risk managers can’t receive a bonus linked to the results of the trading department they supervise (okay, makes sense)
  • bonusses should be linked to the results of the trader, the department and the total firm and cannot be derived from the P&L alone anymore
  • at least 50% of the bonus will have to be payed out in non-cash items, such as shares.
  • at least 40% of the bonus will have to be payed out after at least three years, and pay out is conditionally.
  • the above percentage of postponement of bonuses will be 60% when “very high” bonuses are involved
  • any bonus, including the conditional part, will be retained if company isn’t doing well
  • traders are not allowed to hedge themselves for the exposure of the bonus in shares
  • regulation overrules individual contracts, so all contracts need to be renegotiated
  • everything is applicable to foreign divisions too, including off shore accounts
  • the ratio between fixed salary and bonus cannot be very high. For many traders their bonus will be capped at one years basic salary

As mentioned before, only the firms with a license to be a market maker in the cash market (stocks) will be affected. These firms are for example Optiver, IMC, Flow, Tibra, Liquid and All Options. Under Mifid I the smaller market makers in the options business have an exemption in this regulation by the DNB and AFM. However, next year they will be forced to comply with the bonus regulation as well as MIFID II will start somewhere in 2012 under which they will lose their exemption. As it looks now, also the leverage they can use might be impacted as they will be subjected to the same capital regulations as banks, but that’s another topic for another day.

Liquidity providers didn’t create any trouble last time I checked. Maybe some firms widened their quotes in the long term options, and others simply went bankrupt or had to cut staff. Nothing in systemic risk over here. In 2009 there was an agreement the market makers wouldn’t be hit with new regulations. Nobody knows what happened, but rumor has it the hedge fund industry has pushed government to take action against the market makers too. Hedge funds see market makers as unfair competition.

Question remains whether the measures will really be this as though as they seem now. Can’t imagine that, but it’s only a few weeks till Christmas. Time is running out, and management at the big market maker firms will try hard to avoid this nightmare scenario. At least the payment in shares will be first on their list to fight. Time will tell. In the mean time, I’ve put up for sale my Sinterklaas presents on eBay.

Jack
Jack