Hormones And The Trading Floor

Here is the review of an interesting book that I wrote for Business Standard. The book is titled "The Hour Between Dog and Wolf: Risk-Taking, Gut Feelings and the Biology of Boom and Bust" and it's been written by a Wall Street banker turned neuroscientist, John Coates.

Folklore is full of stories about shape shifters, men turning themselves into wolves or other fierce beasts at the stroke of midnight on a full moon night. What probably gave birth to the myth was the chilling sight of vicious, bloodthirsty marauders on the rampage in ancient times. These intruders often wore wolf skins (or bear skins in some cases) for protection against the cold — and, maybe, to generate a sense of dread. Whatever it was, the ploy seems to have succeeded and a horror story was born, giving rise to a cottage industry of books and movies about imaginary werewolves.

A link was created between the shifts in lunar patterns and changes in physiognomy. While the apocryphal might seem absurd to the untrained eye, there is a whole lot going on just below the surface. The symbolism of man turning into beast has held the interest of assorted scholars for centuries. At the same time, philosophers and scientists began to peer inside the mind, trying to figure out whether the brain had any role in all this.

And now Wall-Street-trader-turned-neuroscientist John Coates comes racing down these old, familiar neural paths with a new gig in town. He shows how human beings think with their bodies in addition to their brains. Using the familiar setting of a bank’s dealing room, Mr Coates explores the impact risky situations can have on the mind as well as on the physiology. He shows how, when confronted with the threat of risk, biology takes over and transforms us into different people. Hence the analogy between dog and wolf.

Mr Coates shows how there is feedback loop mechanism between the body and the brain, and the two act on each other to prepare the entire being for responding to different situations — elation, depression, fear, grief, rage and so on. Using the events that led to the financial crisis in 2008, Mr Coates tracks the different desks and their dealers on the trading floor. The sequence of events and the reaction of the traders – we do not know for sure whether they’re real or fictional – set the stage for him to build his hypothesis.

Ask anybody on the Street about the reasons behind the 2008 financial crisis, and nine out of ten will probably tell you that untrammelled greed caused it all. Mr Coates, however, has a different take. He argues that the frequency of financial meltdowns has increased over the past few decades. One of the reasons is the fundamental change in the nature of the markets — deregulation, opening up of new markets across the globe (especially Asia), lower interest rates, relaxed margin requirements and easy liquidity. But there is another pressing reason: traditional partnerships on Wall Street and London have been replaced by corporate structures that have (supposedly) shifted the priorities from long-term stability to short-term profits.

But, importantly, the market volatility ensuing from these changes has been heightened on both sides of the curve, primarily due to the traders’ biological reactions to enhanced opportunities and threats that occur far too frequently now than in the past. Mr Coates believes that the risk curve might have been amplified because of hormonal build-up in the body of the traders, thereby shifting their risk preferences to extreme levels.

This is what he says: “...under the influence of pathologically elevated hormones, the trading community at the peak of a bubble or in the pit of a crash may effectively become a clinical population. In this state it may become price and interest-rate insensitive, and contribute greatly to the violence and intractability of runaway markets...”

Therefore, the familiar exercise of risk modelling now needs to add another important variable to the stew pot — the clinical state of the trading community under extreme scenarios. This leaves room for a sequel: how to assign values to different emotional states.

It’s an interesting book written from an interesting perspective. Given the huge success of books attempting to decipher what’s going on inside the skull – the popularity of Vilayanur Subramanian Ramachandran’s books (Phantoms in the Brain, for example) is ample testimony to this phenomenon – Mr Coates has a novel approach. He has married his two familiar stomping grounds, the brain and the trading floor. But then, the thesis accords a secondary role to another critical ingredient in the mix: the role of perverse incentives. Seen in that context, it might be a bit too glib to explain away all that has happened to only hormones and changes in the body’s chemical balance. There is one way to test this hypothesis: try explaining it to those in the manufacturing sector who have lost their jobs because of the excesses in financial services.