Question

Wall Street firms have traditionally compensated their traders with a share of the trading profits that they generated. How might this practice have affected traders’ willingness to assume risk? What is the agency problem this practice engendered?

Short answer

This encourages them to take extraordinary risks.

Misdeeds of one trader are most likely to be facilitated and carried forward by other traders

Step-by-step solution

Definition

The potential conflicts of interests between shareholders and managers are known as agency problem. In such cases, the managers may pursue their own interests and not that of its shareholders, for a variety of reasons.

Explanation

Allowing compensation with a share of trading profits to traders is an agency problem as traders get incentivized but not penalized on trading losses. This encourages them to take extraordinary risks.

This also creates a vicious cycle where the misdeeds of one trader are most likely to be facilitated and carried forward by other traders.