notes-econ-financeTradingRiskManagement

The goal is to develop a system that incentivizes traders to self-manage without a risk desk. The problem with paying traders proportionately is that traders are incentivized to make "black swan" trades, that is, trades with negative expected return but which almost always return positively, because when the large negative returns hit they don't lose as much as they gained from the positives.

1) allow anyone to go on your website and "paper trade"

2) if they do well, hire them, give them some money to play around with, and give them equity in proportion to the money you gave them. but they also incur a debt to you in the same amount as the equity value (or it could/should just be "phantom equity" -- in which case almost all of the pseudo-profits should go to the phantom equity, and very little residual profit should go to the investors/owners)

3) if they make money, they get paid proportionally, plus pay from the equity (the equity pay is in place of a salary -- of course i guess you have to pay minimum wage no matter what but that's peanuts compared to the money they can lose, and then money they hope to make)

4) if they lose money RELATIVE TO A MINMUM RATE OF RETURN which is max(the firm's ROC, 0), then take away the equity proportionately. Of course this is tricky because of timescale, etc -- you probably want a long-term ROC. Maybe the risk desk uses some fancy model here, or maybe they can even forgive un-risky traders who were still "trying". The only people we want to weed out are ppl who don't even try to trade and just go on vacation or take another job -- or equivalently make a pretence of showing up but actually just keep all the money in bonds or moneymarket funds or a single index ETF or whatever. Note: if the risk desk does not have subjective power here then traders won't care about it, it's just a machine. If they do, now the risk desk is loved by the traders instead of disrespected -- b/c the risk desk forgives and the risk desk empowers (instead of the current system, where the risk desk appears to get in between you and your profits).

5) if they lose all their equity they're fired

6) if they leave or are fired, they have to sell you back the equity at a set price -- in forgiveness for the debt (note: this may not even be necessary with #4 or if the equity is "phantom" which is probably a good idea)

Now there is still a risk desk that decides to whom to give more equity and how much. But at least they aren't involved in approving individual trades.

Equity becomes available to the risk desk to reallocate as traders underperform.