Infectious Greed

by Frank Partnoy

  As 1987 began, Krieger found what he believed was an incredible opportunity to make money trading currency options. The U.S. Federal Reserve and various central banks in Europe had implemented policies to maintain their currencies within a stable zone. The dollar had been falling for several years, but during 1987 it stabilized, and by the fall of 1987 the volatility numbers traders were using to evaluate currency options were very low. As a result, currency options were incredibly cheap.

  Krieger thought traders were foolish to assume that the values of currency options should be based on the recent low-volatility levels. Any student of history understood that currencies had been unusually calm. Just a few years earlier, currencies had been much more volatile. Krieger thought the dollar would fall, and he began buying options that represented bets against the dollar.

  In addition, Krieger had a trick up his sleeve. At Salomon, Krieger had begun developing techniques to increase the amount of currency other banks would be willing to trade with him, by taking advantage of other traders’ greed. For example, if Krieger needed to sell a large amount of a particular currency—say one billion British pounds—when no one in the market was willing to transact in that size, he first would place an order with traders at other banks to buy one billion British pounds at a price below the market price. Greedy traders at other banks would then begin buying hundreds of millions of British pounds in an effort to “front run” Krieger, profiting from the increase in the value of British pounds they thought would occur due to Krieger’s increased demand. But then Krieger would sell British pounds to the banks, as he originally had intended, instead of buying. This whipsaw strategy made it easier and more profitable for Krieger to trade his positions.

  Krieger was taking advantage of the fact that, given the limited set of variables driving supply and demand in the short run—including the fact that many foolish central bankers consistently lost money trading even their own currencies—many traders believed they could profit from manipulative strategies within a particular day, just by buying or selling large amounts of currency. If these traders had been buying and selling stocks instead of currencies, such efforts to move short-term prices would have constituted “market manipulation,” which was illegal in most stock markets. But the currency markets were an unregulated free-for-all, where manipulative trading tactics were quite common and perfectly legal. By manipulating prices, a trader might be able to generate profits even if the markets were otherwise efficient. This was something the academics studying financial markets hadn’t yet considered. And it was something the traders loved to do.

  Manipulative practices were especially common in the over-the-counter markets—the wild Wild West of trading. Instead of buying and selling options on a centralized exchange, which acted as the counterparty to all trades, traders could enter into private contracts with buyers and sellers, typically other banks. These trades were called over-the-counter, because the options buyer was like a person walking up to the counter in a store and buying something from a storekeeper. The exchange and its regulators wouldn’t play a role; they might not even know about the trading. Instead, counterparties to a trade would agree to a private contract “in the wild,” specifying the terms of a particular currency option and the rules to govern their contract. The exchanges monitored manipulative practices, but nobody watched the over-the-counter traders.

  The difference between the exchanges and over-the-counter markets was dramatic. An exchange is like a Las Vegas-casino sportsbook, where a gambler can place a limited set of bets, perhaps on who will win a sporting event or on how many points teams will score, but not on anything much more specific than that. Casinos, like exchanges, aren’t in the business of taking risk, so they only “make book” for bets if they know there will be gamblers on both sides. In other words, casinos and exchanges are simply intermediaries for standardized bets, and they make money by keeping a percentage of the bet, not by taking on risk.

  As a result, casinos and exchanges allow bettors to place only a narrow set of prespecified bets. On Super Bowl Sunday, casino gamblers can place more exotic bets—which team will kick the first field goal or which player will have the most rushing yards—but even on that special gambling day no one can bet on whether a kicker will hit one of the goalpost uprights or on whether a player will rush for more than, say, 126 total yards.

  Such limitations didn’t apply in the over-the-counter markets, where gamblers and traders could design any trade they wanted. Imagine a counter at the casino sportsbook, where gamblers could find several counterparties willing to place any bet at all. With no supervisor or regulator to say what they could or could not do, gamblers would be limited only by their imaginations.

  Andy Krieger had a powerful imagination, and during 1987 he was trading a vast array of over-the-counter options not available on the exchanges. These options had customized features based on numerous currencies. For example, many of Krieger’s big trades—including a few of what he described as “nasty experiences”—were options on the New Zealand dollar, a currency traders affectionately called the “kiwi.” (The dollar coin has a kiwi bird on one side.)

  It was much easier to make money in the over-the-counter markets than on the exchanges, especially if a trader could use options to hide his trading strategies from other traders. Krieger placed hundreds of trades each day at Bankers Trust, although he made most of his money on five or six major “plays” every year. Krieger still abhorred the “naked” selling of options; so, for his major plays, he typically bought options—in industry parlance, he was long. As he put it, “I am always net long of options. My downside risk is always defined and limited.”23

  It is worth pointing out that these positions were hidden, not only from other traders, but also from investors in Bankers Trust. The bank’s shareholders would have been quite surprised to learn that instead of owning a stake in a bank that made loans or perhaps held junk bonds, in reality they were rolling the dice with a bet on the New Zealand kiwi.

  Krieger attributed some of his success as a trader to a strategy in which he would indicate to the market that he was taking a particular position, when in reality he was taking the opposite one. In referring to practices such as feigning one way while really going the other, which might be regarded as manipulative in other markets, Krieger noted that “there was nothing illegal about it,”24 and he was absolutely correct. Krieger’s misdirection plays grew over time until they involved billions of dollars.

  Krieger masked his strategies by using a combination of options and other trades to make it look to the outside world as if he were placing the opposite bet of his true one. His misdirection strategy was like judo: he tried to beat other traders by making them move in the wrong direction first, then using the directional force of their own trading positions against them. On occasion, Krieger trading positions became so large that they dwarfed Bankers Trust’s other businesses.

  In one infamous episode, Krieger sold, or shorted, roughly the entire money supply of New Zealand.25 He also held call options—of similar amounts—which would benefit if the kiwi went up, and therefore would offset any losses from his short position. With these two bets, Krieger faced two possibilities: first, if the kiwi rose, he would break even, because the money he lost on his short bet against the kiwi would be offset by money he made on his call-option bet that the kiwi would go up; second, if the kiwi fell, he would make money, because he would profit from his short bet against the kiwi, and would simply let his call option expire worthless (recall that as an option buyer he was not required to buy kiwi). In sum, Krieger paid money upfront for a bet that made money when the kiwi went down. In other words, Krieger had—in a convoluted way—bought a put option on the kiwi: the right to sell kiwi at a specified time and price.

  Krieger’s strategy drew from one of the central insights of modern finance, generally known as parity (or put-call parity), and it is worth taking a few minutes to contemplate. It is one of the mind-blowing concepts of
modern finance, and investors who don’t understand it are disadvantaged relative to those who do. Parity has become—and will continue to be—a major theme in financial markets.

  Here is the parity notion, simply put: there are many ways of creating a bet, all of which should have the same value. This notion is sometimes called the Law of One Price. For example, suppose I want to bet $100 on New England in the Super Bowl. One way is simply to bet $100 on New England. Another would be to bet $100 on St. Louis and $200 on New England. In the second strategy, some people might think I had bet on St. Louis, even though—on a net basis—my money was on New England. I feigned the favorite, but really bet the underdog. Either way, the value of the betting strategies should be the same, because the two strategies have “parity”—they are both really $100 bets on New England.

  The same parity principles work for currency options. One way for Krieger to bet that the New Zealand kiwi would fall was to buy a kiwi put option, which gave him the right to sell kiwi and became more valuable as the kiwi declined. But Krieger also could make exactly the same bet by doing two things: first, selling—or shorting—the kiwi outright; second, buying a kiwi call option, which gave him the right to buy kiwi and became more valuable as the kiwi rose.

  The second strategy was more complicated, but both strategies performed the same, regardless of how the value of the kiwi changed. If the kiwi went up, Krieger broke even with either strategy (the put option was worthless; the short position and call option cancelled each other). If the kiwi went down, Krieger made money with either strategy (the put option became valuable; the short position also became valuable, and the call option was worthless). With either strategy, Krieger didn’t care what happened if the kiwi went up, and if the kiwi went down, he made money. In other words, buying a put option was equivalent to shorting plus buying a call option;26 because these two strategies had “parity,” they should have the same value.

  Why might Krieger employ the second, complex strategy instead of the first, simple one? The reason, according to Krieger, was that some traders might not know about both trades, because options were traded in separate markets from the currencies they were based on. In both the options and currency markets, there were a handful of dealer banks, and a trader from one of these banks typically would buy and sell from any of several people: the bank’s customers, the relevant central bank, and traders’ other dealer banks. There was no centralized exchange; instead, it was an over-the-counter market in which traders simply phoned each other all day long and agreed to trade at different prices. Traders made money by buying low and selling high, and thus were pitted against each other. Frequently, a bank employed one person to trade currency options and another person to trade the currencies themselves.

  Some traders would see only Krieger’s short position, and would think Krieger was betting against the kiwi (and therefore would be hurt by a rising kiwi). Traders in over-the-counter markets frequently tried to profit by manipulating the market in the opposite direction of a bet they knew a trader at another bank had placed. For example, if another trader had bet that the kiwi would fall, they might try to take advantage of him by buying kiwi, trying to push the price upward, until his losses became so painful that he was forced to unwind his bet. Then, the dealers would sell their kiwi at a profit.

  However, currency traders dealing with Krieger apparently didn’t know that Krieger’s short position was only half of the story. Because Krieger also bought a call option in the options market, he wasn’t vulnerable to a rise in the value of the kiwi at all—any money he lost on his short position was offset by a gain from his call option. When traders attempted to force the kiwi up by buying kiwi, Krieger didn’t lose money—but now he knew they had bet that the kiwi would rise, and he could take advantage of them by selling kiwi. When their losses became so painful that they were forced to unwind their bets, Krieger could unwind his position at a profit.

  In the unofficiated world of currency trading, Krieger’s ploy worked perfectly. He could dodge his opponents’ punches, and then—with a judo move—fling them to the mat.

  Krieger was quite proud of this strategy, and bragged about his misdirection play on several occasions. Stunned traders would tell him, “Huh? Uh—you want to sell the pounds?” or “You want to sell the kiwi?”27 According to Krieger,28 [I]t was unusual for my cash positions to correspond to my market views. At Salomon, Bankers, and Soros [where Krieger later worked], banks would often observe my trades or look at my cash positions and believe that they corresponded to my market views. But often that wasn’t the case. Usually my cash positions were hedges against my option views. Sometimes I used my cash positions to put on synthetic option positions, or as a hedge to reduce exposure in a position that I thought would continue the opposite way of my cash position. In other words, just because I was short pounds in spot didn’t necessarily mean I was bearish on the pound. In fact, I might have been wildly bullish on the pound—and was simply taking some profits by selling some pounds against an otherwise more dominant option portfolio.

  That sneaky Andy Krieger! Until other traders figured out the connection between currency and options markets, Krieger could use parity as a sword, profiting from this misdirection play. And remember, these markets were unregulated, so market manipulation was perfectly legal. Indeed, manipulation was precisely what other traders were trying—and failing—to accomplish.

  Krieger’s strategies were far from foolproof, although he insisted that they were low risk. He claimed he needed to be correct only about 25 to 30 percent of the time to “yield substantial results.”29 He said he limited his downside risk by spending only 10 to 15 percent of his capital to buy options. The result: “So, even if I’m wrong on every play, the downside is quite tolerable.”30

  Nevertheless, Krieger’s strategies obviously wouldn’t have been appropriate for many investors. The strategies resembled an average investor putting her savings into stock options, or a tourist putting his travel budget into currency options. These strategies worked for Krieger for two reasons: first, he used his superior knowledge of pricing models to buy cheap options during periods of market inefficiency; second, he used his misdirection play to take positions he believed were good bets. A little luck wouldn’t hurt his strategies, either.

  Krieger was clever, but not that clever, and soon other traders would grasp what he was doing. When they did, Krieger would shift to a more dependable, lower-volatility trading strategy, which would prove to be more appropriate for individual investors. But until then, Krieger’s misdirection strategy was the $20 bill on the ground. It wouldn’t be there for long.

  During 1987, Bankers Trust’s newly appointed chairman and CEO, Charles S. Sanford Jr., was encouraging his traders to speculate with the bank’s capital, and he seemed to believe Krieger had a winning strategy. Sanford reportedly gave Krieger a whopping $700 million of capital to use as a base, much more than he gave other traders.31 With that much capital, Krieger easily could control billions of dollars of currency positions. Suddenly, the 29-year-old trader had access to more capital than virtually any other trader. He could place bets that rivaled those of many central banks.

  Although Krieger’s bets during 1987 were quite complex, his strategy essentially was to bet that the dollar would fall. As Krieger settled in at Bankers Trust, his bets got bigger and bigger, and as he made money he “played with his gains,” increasing the size of his trades. In June 1987, Krieger sold $1 billion of German marks and mark options, betting that the U.S. dollar would appreciate relative to the mark; he made more than $70 million on that trade. Later, Krieger referred to the risk associated with a $3 billion position in German marks.32 He also told Institutional Investor magazine, “As a straight open-spot position, I wasn’t happy going any more than $700 million—so I was comfortable with, say, a 2 percent loss of $10 million to $15 million. But if I wanted to take a really serious view, I would take an option position, which might start as an investment of, say, $4 million or
$5 million. The position might end up controlling $1 billion or $2 billion of currency.”33 A billion here and a billion there—and pretty soon Bankers Trust was betting some serious money.

  During 1987, Krieger made such huge bets against the New Zealand kiwi that his trading caused a ruckus in Wellington, where—as one trader recalled—the kiwi fell “like a wounded pigeon.”34 As the currency plunged, some of New Zealand’s banks lost huge sums, because their assets were denominated in kiwi. At first, banks couldn’t identify the source of the downward pressure on their currency. But, eventually, they found their man, through private investigation of the unregulated and anonymous over-the-counter markets. According to public reports, when government officials eventually traced the trading to Bankers Trust, New Zealand’s chancellor of the exchequer telephoned Chairman Sanford to complain.35 But New Zealand officials privately told Bankers Trust they had known about Krieger’s bets against their currency and were happy about the decline, which would make exports cheaper and help spur economic growth. In any event, Sanford paid no heed; Krieger had made too much money for Sanford to worry about a miffed central banker.

  After the U.S. stock market crashed on October 27, 1987, the dollar briefly increased in value, as foreign investors rushed to put their money into U.S. Treasury bonds, which were regarded as the ultimate safe investment. Oddly, the higher price of the dollar began creating higher demand, the opposite of what basic economics suggested (economists generally believed that higher prices led to lower demand). At this point, Krieger thought it was so obvious that the dollar would crash that “it was just a gift—it was almost disgraceful to make money on this trade. It was one of the easiest trades I’ve ever seen, a special opportunity.”