What Do Financial Engineers Do?

"Engineering is not merely knowing and being knowledgeable, like a walking encyclopedia; engineering is not merely analysis; engineering is not merely the possession of the capacity to get elegant solutions to nonexistent engineering problems; engineering is practicing the art of the organized forcing of technological change. Engineers operate at the interface between science and society." - Gordon Brown

The function of finance is to connect providers of capital with users of capital. This can be a simple process. For example, a venture capitalist might find wealthy individuals to fund start-up companies. This venture capitalist might make use of tools such as a spreadsheet and quantitative theory such as discounted cash flow valuation, but has little need for a specialized financial engineer.

Most finance is done is more complicated ways, using intermediate institutions such as banks, exchanges, and special purpose entities. Many people with technical skills are needed to keep this system running. I do not consider them financial engineers, however. They work in finance and have quantitative skills, but they are doing niche jobs for which the field of application doesn’t matter much. Designing databases or solving equations for a bank is not essentially different from doing the same tasks for, say, a parcel delivery service or an aircraft manufacturer.

I define a financial engineer as someone using technical skills in the finance industry whose work is informed by the end-to-end, capital provider to capital user, effects of what he does. It is not necessarily a better or more honorable profession than the specialists who make up most of the financial technical workforce. It does require different attitudes and skills, and it presents different challenges and offers different rewards.

There are three characteristics any engineer must have. First, she must accept reality. She does not spend effort worrying about how things might have been different, or complaining to the universe or agitating for other people to change their ways. She is not concerned with opinions, untestable propositions, or abstractions that do not affect decisions. Second, she must have a vision for how things could be better. It need not be an individual vision, many engineers function best on group projects, but random tinkering is not engineering. Third, she must have the drive and skills to accomplish her vision through her own efforts. She can fail at the third step and be a failed engineer. But if she fails at either of the first two steps, she’s something other than an engineer. The engineer’s prayer is, “Thank you ____ (fill in whatever you feel gratitude toward for existence) for the universe and for my eyes, my hands, my brain. I’ll take it from here.”

This definition generates two questions. Do you need a financial engineering degree in order to be a financial engineer? The answer is “no”; some of the greatest engineers in history were self-educated. However, a good financial engineering program is the most efficient way to pick up the necessary knowledge. You would have to work for many years, in many areas of finance, to become familiar with the financial system end-to-end through direct experience. You can learn most of the technical skills from books and the Internet, but not the practical details that are essential to sound engineering. Thirty years ago, a quant with a good general education, a curious mind, and a diverse set of industry contacts could teach himself. Today it would be extremely difficult.

The second question is whether there is any reason to enter a financial engineering program if you do not want to be a financial engineer. This one is tricky. The reason employers hire people from financial engineering programs is they need employees with a breadth of technical financial knowledge. Only a few employers want engineers of any stripe; engineers can be disruptive. Employers are more likely to be looking for technical specialists who can move to different areas as needed, and who might avoid some tunnel vision mistakes of a quant without general financial training. So you might be tempted to get a financial engineering degree in order to have a better chance of getting a job as a technical specialist.

That can work, but I think it’s rarely a good idea. The trouble is people like that usually have short careers in finance. When you amortize the cost of the program along with the lost employment time while in the program, you might well end up making more money in a lower-salaried, less volatile career. More important, that lower-salaried career can progress naturally. You won’t face a mid-career transition after being laid off from a high-paying job, having to start over in some other field. Another point is there are probably cheaper and easier things you can do to improve your chances of landing a technical specialist job in finance than get an MFE.

What is it like to be a financial engineer? I have to start with a caveat. The world is changing fast, and the financial world is changing faster. It’s easier to predict functions than institutional roles. For example, I’m pretty confident financial engineers will be describing the possible evolution of derivative prices for many years, and probably using some kind of generalized Monte Carlo to do it. But I have much less confidence that they will be doing it on anything like a modern dealer trading desk. Over my career, I have seen species of financial businesses spring up, evolve, and die out.

Nevertheless, to prevent this from getting too abstract, I’m going to use current institutional terms. Just remember to focus on the functions of the job, not how it is embedded in a financial business.

Let’s begin with front office jobs, jobs in groups that generate direct revenue. These are the most exciting jobs with the best pay, also the most volatile and the ones where luck plays the greatest role in career success. They reward aggressive, confident financial engineers, and may require subordinating personal lives. On the other hand, they allow the most professional freedom. Front-office financial engineers can choose to work in a wide variety of circumstances from one-person start-ups to the largest companies. A disadvantage is front-office skills are not transferrable to other professions. If your professional rewards and satisfaction are the biggest things in your life, and if you are sure finance is for you, the front office may be the best place to work.

The two forms of revenue in finance are trading profits and many flavors of fees. Financial engineers are needed to design and support trading strategies, create and manage structured products, develop software to be used in pricing or hedging, and other tasks that combine aspects of all three functions. The reason you should have a financial engineer for these tasks is all the revenue is extracted from a highly complex and fast-changing financial system. It’s not enough to write good code or solve equations properly; front-office quants need to build systems that can thrive in a chaotic and competitive environment.

Next come back-office jobs. There are a lot more of them than front office jobs, and they afford better work-life balance. Success will depend on ability more than on luck and politics. Careers will be more predictable and if you do decide to leave finance, your acquired back-office skills will have some value. Your achievements are likely to have longer useful lives. Pay and excitement are lower than in the front office. Financial engineers can play important roles in back-office areas such as financial control, especially risk control, and systems development.

Back office is sometimes referred to as the “plumbing” of the financial system. Like plumbing, everyone ignores it when it works, but when it doesn’t work, life can be very unpleasant. Also like plumbing, it’s a lot more complicated than most people imagine.

Finally there is the middle office. A century ago, there were literal physical front and back offices in brokerage firms, the front office for clients and the back office for clerks. There never was a real middle office. The term was invented in the 1980s to describe risk management, because risk managers used front-office skills, and sometimes got injected into front-office decisions, but did not generate revenue directly. There’s no generally agreed definition of the term; some people include departments such as treasury, information technology, legal, and compliance. Financial engineers are most often found in risk management and, if you include them in middle office, front-office IT and risk IT.

In some respects—pay, glamour, and career volatility—middle office is (as you might expect) midway between front office and back office. In another respect, however, it differs from both front and back office. Middle office requires financial engineers. However specialized a financial task or institution, it can be affected by the end-to-end chain of capital in which it is embedded.

The great British engineer Henry Royce defined the simple ethos of the profession: “Strive for perfection in everything you do. Take the best that exists and make it better. When it does not exist, design it.” This is a proud and noble undertaking, for those with the talent and energy to attempt it. And today, finance is one of the most exciting and useful places to practice engineering. You take it from here.

Aaron Brown is risk manager at AQR Capital Management and the current Global Association of Risk Professionals Risk Manager of the Year. He is the author of Red-Blooded Risk (Wiley, 2012), The Poker Face of Wall Street (Wiley, 2006, selected one of the 10 best books of 2006 by Business Week) and A World of Chance (with Reuven and Gabrielle Brenner, Cambridge University Press, 2008). In his 31 year Wall Street career he has been a trader, portfolio manager, head of mortgage securities and risk manager for institutions including Citigroup and Morgan Stanley. He also served a stint as a finance professor and was one of the top professional poker players in the world during the 1970s and 80s. He holds degrees in Applied Mathematics from Harvard and Finance and Statistics from the University of Chicago.

A version of this article appears in the QuantNet 2013-2014 International Guide to Programs in Financial Engineering