The World According to Victor Neiderhoffer
Victor Niederhoffer is the author of The Education of a Speculator, one
of the oddest-and most popular-books about finance ever published. He is
chairman of Niederhoffer & Niederhoffer, a top-ranked futures trading
firm with $100 million under management that boasts a 32 percent compound
annual return since 1982. Niederhoffer, whose clients include George Soros
and others, uses a number of statistical models to discover pricing anomalies.
While explaining the principles of speculation he learned while growing
up in Brighton Beach, Brooklyn, he regales his readers with discussions
of sociology, music, economic theory, sex, squash, statistics and poker.
The book is also full of trading advice about mechanical trading systems,
self-reliance, and protecting yourself from tactical deceptions and institutional
Derivatives Strategy: You have a unique vision of how the food
chain works in the financial markets...
VN: Each futures and foreign exchange market is held together
by a web of public, dealer, large speculators and broker players interacting
with each other and their market environment. Food and energy, in the form
of losses, is created by "the public" and other slow-moving participants.
DS: Who is a member of the public in this scheme?
VN: There are many publics, but most of them are shy about wearing
their badges. They can be found among futures traders, stock flippers, market
timers, system clubs and tape watchers. But because of the high morbidity
and mortality within these groups, membership is always in flux. The best
way to identify the species is by behavior-inflexibility, ignorance, arrogance,
myopia, hesitancy, undercapitalization, overconfidence, spendthrift ways
I'm not ashamed to admit that I am occasionally part of the public. I
often trade with dealers in foreign exchange paying a 5-basis-point bid/asked
spread when my exit point is a 25-basis-point profit or loss. I have also
been known to accept a derivatives or options trade where, if I exited instantaneously
after entering, my loss would be 50 percent of my cost.
My life expectancy in such activities would be lower than that of a mouse
playing with a lion. Yet I persist. The life-enhancing factor is that I
usually try to take the opposite side of public trades. The role of the
public is to be eaten.
DS: And who eats the publics?
VN: The primary consumer of the "publics" are dealers,
banks and brokerage houses. The dealing banks are very good at going about
their trade. Year after year, publicly held banks and brokerages report
annual profits in the $10 billion range from their foreign exchange and
DS: And how do you explain these kind of profits?
VN: Professor Robert Aliber of the University of Chicago has analyzed
the abnormal profits of banks in the foreign exchange markets in recent
years. One day, he arrived in my office late with a poignant reason: The
chairman of a money center bank he had been visiting had kept him waiting
while he, the chairman, negotiated the year-end bonuses of three foreign
exchange traders who had made the bank $250 million over the year. Professor
Aliber concluded that the foreign exchange profit of money-center banks
is inordinately large relative to the capital they employ in these activities.
He believes these profits compensate dealers for the persistent needs of
importers to buy foreign exchange and the external desires of hedgers to
Paul DeRosa [a hedge fund manager] takes another track. He notes that
bonuses to foreign exchange dealers are typically one-fourth the level paid
to counterparts in the fixed-income field. He attributes the low ratio to
the knowledge of the bank managers that it's the system that creates their
profits. The two key contributing factors are the wide bid/asked spread
and the use of limit and stop orders by slow moving participants.
I believe dealers play the role of the house, in imitation of the casinos
in Las Vegas and Atlantic City. In 1995, cash foreign exchange trading amounted
to about $1.2 trillion a day in volume-of which approximately one-third
involves the public with banks and two-thirds is directly between the banks
in the interbank market.
DS: How do the profits break down?
VN: In a typical foreign exchange transaction, a bank will quote
a market of $/¥ 100.05/100.15 on 1 billion yen. The banks spread amounts
to 0.10 percent, or 10 cents per $100 of each trade. Assuming the orders
are balanced, the bank's profit would be one-half the spread on each transaction.
Multiplying the figures out, the average amount gained by the bank per
year would be $50 billion per year. (1/2 x. 0.10 percent x 1/3 x $1.2 trillion
x 250 trading days = $50 billion.)
The amazing thing, then, is that reporting banks make only $8 billion
to $10 billion a year from their foreign exchange business. Assuming that
those amounts come to 80 percent of total revenues, the profits come back
to a figure close to the amount estimated from the bid/asked spreads. No
wonder many holders of foreign exchange don't bother to hedge unless they
expect a 3 percent move against their holdings.
DS: What advantages do they have in this game?
VN: One factor that tends to enhance banks' profits is the lack
of a central clearing mechanism for foreign exchange. A customer must, for
all intents and purposes, exit a position at the same house where the trade
was entered. Consequently, the bank always knows which way a customer will
go. Because money must be deposited in advance, most customers desire to
leave the bank just enough funds to cover the size of their positions. This
enables the bank to know which way the customer will go once it has used
up its available margin funds.
For example, assume a customer with $10 million on deposit holds, as
a 5 percent margin against the value of foreign exchange, long positions
of $200 million. If the customer asks for a quote, the bank will know he
has to sell dollars and will be inclined to quote a bid/asked spread that
is biased to a low dollar bid. Customers placed in this position remind
me of ads for the Roach Motel-easy to check in, very tough to check out.
No matter how hard I try to reduce this edge, the banks are always one
step ahead of me in closing down the pass. Just before I extricate myself
from a trade I like to call the banks and ask how much I can add to my position.
"Victor, why are you going to all this trouble to jerk us around?
We know you never add to a winning trade," they say. Somehow they always
DS: Are these advantages changing?
VN: In all systems where one species preys on another, there is
a constant evolution of the techniques that both groups use to maintain
their margin of benefit. One technique the banks utilize with good effect
requires that all customers deposit money in advance of a trade, purportedly
so the banks will not have any credit risk on the transaction. The banks
justify this deposit by alluding to the differences in settlement times
and banking hours in various countries when the transactions are settled.
DS: The so-called Herstatt risk.
VN: Yes. That's been used ever since as an example of the great
risks banks face. Payment up front results in major benefits for the bank.
In addition to the Roach Motel bit, the customer's funds can be invested
at a profit by the bank, to the extent that they earn more in the Fed funds
market then they pay us in interest.
DS: What do traders like yourself do to balance the equation?
VN: One strategy is to unload positions on several banks simultaneously,
so that the banks are forced to get out at a loss when the trades start
coursing through the system. To prevent this from happening, banks frequently
delay making a quote until the other counterparties the customer might be
trading with have indicated a direction. "You're in line," I often
hear when I have a trade of some real size to do.
On the rare occasions when I am able to get out of a trade with a bank
without an immediate loss, I invariably get a call from the sales manager
at the bank the next day. "Vic, my dealer complained. We thought we
were seeing your whole business. But whenever you call us for a quote, we
hear your activity with others over the squawk box. We're making you five-point
spreads. And we're beginning to wonder why."
Well, I tell them, the reason is that you make $1 billion a year on transactions
like that. You don't hear me complaining about the 90 percent of the trades
I have a loss on, do you?"
DS: Are the fixed-income markets different?
VN: Dealers in fixed-income make a comparable bid/asked spread
profit. Trading again is on the order of $1 trillion a day. The spread on
a typical transaction would be 100 1/32 or a 2/32 spread, which is .0625
percent per $100 item. This is of the same order of magnitude as the 0.10
percent spread on the foreign exchange trade.
Unlike their foreign exchange counterparts, the government dealers do
not insist on a security deposit, and customers are not locked into a particular
position with a bank. Government securities can be delivered against each
other at various clearing banks or brokers. Perhaps because of this lack
of edge, government dealers typically refuse to quote a two-way market.
The standard patter goes like this:
"Linda, Niederhoffer here; kindly offer $10 million on the long
"We're at 100 3/32."
"Bob [the dealer sitting next to her], you can sell $10 million
of the long bond to Niederhoffer."
The broker protects himself from being exposed the wrong way on a trade
by knowing the customer's direction in advance. Finally, the time between
the salesperson's relay of the offer of a trade and the dealer's confirmation
that a trade has been made enables the dealer to guard against a move against
him during the 10 seconds or so that the trade is open.
DS: And what role do hedge funds play?
VN: They're the highest link in the web, the secondary consumers,
who feed on the banks.
DS: What's the hedge fund's secret? They can't make it on the
bid/asked spread the way dealers do...
VN: Well, certain naive commentators attribute the return to a
constant interchange between government officials and traders, which seems
to mark all successful funds. But that doesn't account for how all that
information enables the predators to overcome the bid/asked spreads.
The returns have been abetted in recent years by the tendency of hedge
funds to borrow short and invest long in equities and debt. During a rising
market such leverage works great, but something deeper is going on.
Dealers have uncertainty as to the likely variations in the value of
the inventory they hold to conduct their business. The uncertainties surround
the optimum quantities to hold and the prices to pay and charge. To maintain
access to credit, it is helpful for dealers to lay off risk by trading with
speculators who are willing to facilitate their hedging. Like insurance
companies, some large hedge funds are willing to accept these risks in exchange
for a profit. Because dealers generally maintain an inventory of goods to
conduct their business, on balance speculators buy goods from dealers. For
this, dealers charge a price.
The ability to conduct their business while remaining insulated from
fluctuations in the value of their inventories enables dealers to specialize
in the relatively secure activity of capturing spreads rather than speculating
on value. And banks and suppliers are willing to provide more credit to
dealers who are able to insulate themselves from price fluctuations. Frequently
the dealers can engage in a higher volume and a more profitable business
than they could handle if they were not able to lay off their inventory
risk. The dealer's total reward as well as the reward per unit of risk is
enhanced by the activities of the large hedge funds.
DS: How do spreads in the derivatives markets compare with the
foreign exchange and fixed-income markets we've talked about?
VN: The derivatives markets have no compunction about quoting
spreads with an implicit house take of 25 percent. A quote of 0.3 to 0.4
percent for an at-the-money straddle, with three days until expiration is
standard. One of the biggest dealers routinely quotes a 100 percent markup
on such markets.
I try to educate the dealers with some comeback like, "Please don't
put that in writing. If my customers found out I considered such a quote,
they would have you and me locked up." If they don't shape up, I close
A typical bid/asked spread in futures such as silver or soybeans is 1/2
cent on a $5 item, which comes to 0.1 percent. For bonds the most liquid
market in the world, the bid/asked is 1/32 on a $100 item, or 0.03 percent.
These small spreads, plus a comparable amount for commission, don't look
like large hurdles to overcome in isolation; they come to less than 1/10
of the percentage level for stocks. What an illusion. The bid/asked spread
plus commission plus bad execution quickly adds up to a staggering load.