Rogue Trading As Far As The Risk Managers Eye Can See
London, 16 September 2011
Rogue trading has become a mature business characterised by low levels of innovation and familiar patterns. The latest affair involving UBS trader Kweku Adoboli over the $2bn loss in UBS’s London-based exchange traded funds business is just the latest example.
Prior to this, the last case to hit the headlines was a typically pedestrian affair. An oil trader in London, who was only authorized to place trades on behalf of clients, had a punt in the Brent oil market and promptly lost $10 million – more than his firm had made the year before.
The reigning king of rogue traders is, of course, Jerome Kerviel [as distinct from Bernard Lawrence “Bernie” Madoff who was not a trader, just a common thief]. Kerviel dropped an impressive €4.9 billion on behalf of Société Générale in 2008. He was supposed to be doing index arbitrage but was punting. We had previously seen the same story play out at the Common Fund back in 1995.
In addition to a now familiar modus operandi, there are also some well-established patterns among the perpetrators themselves. These patterns might be of interest to those tasked with preventing the next instance. There will likely be very little sympathy for managers when the next firm with a ‘star culture’ and ‘weak controls’, to quote a litany of case studies, gets hit. So what should you be looking for?
No, not the one editing this publication [ Guy Isherwood]. A man, male, gentleman – that is, someone physiologically equipped to initiate conception but not to bear children. To date, rogue trading has not been an equal opportunity affair. With the exception of a gold and silver trader at Citibank who was discovered to have lost a modest $20 million in 2003 and a collateralised mortgage obligation trader at AIB in 2001, they have all been men, [er. blokes in some cases]. There were two other cases in China where female supervisors were held accountable for their male subordinates’ misdeeds (Hunan Zhuzhou Smelting Plant – 1997, China State Reserves Bureau – 2005).
But if we limit the discussion to the people actually causing the losses – where that information is known, the tally is 52 to 2 (96%). Even allowing that the pool of traders may be up to 90% male, 4% is less than half of what would be expected. The male Morgan Grenfell fund manager who showed up in court dressed as a woman counts against the guys here. Your perpetrator is likely to have a Y chromosome.
In 36 cases where the age of those responsible could be determined, the average age at the time of discovery was only 36.5 years. The youngest were 26, including one fellow who was hired in March of 2007 only to blow up 7 months later trading indexes linked to credit- default swaps. Nick Leeson was a fresh-faced 28 year old when Barings went bust. Leeson had been doing unauthorized trades since he was 25. Yasuo Hamanaka, called Mr. 5% because of the share of the global copper market he controlled, had a 10 year run at Sumitomo. Daiwa’s Toshidi Iguchi had an 11 year run, falsifying some 30,000 trading slips. So the average active rogue is younger. Your perpetrator may be in his early 30’s.
He Has a Back or Middle Office Connection
First, beating the system necessitates understanding it. Leeson famously ran both the front and back offices. Barings even allowed his wife to keep the books while her husband traded. Kerviel had worked in the middle office before moving into a trading role. As his losses mounted, he hacked into SocGen’s risk management system to hide his positions. His only drinking buddies were said to be the guys from the back office.
Toshidi Iguchi at Daiwa rose from the back office to become a trader in 1984, kicking off his 11 year odyssey. At NAB, the ring leader helped design the in-house system used for currency options trading. He worked on the front, middle and back office implementation, including systems accounting. The Ludwig report on the 2002 AIB case noted that John Rusnak was able to ‘persuade back-office staff to let normal procedures slip.’ Mr. 5% was allowed to keep his own books without an audit. The chief FX dealer of Croatia’s third largest bank was able to lose nearly three quarters of the bank’s capital on unauthorised trades with the alleged help of a bank clerk who registered his losses as deposits in foreign banks. Your perpetrator may have special knowledge of or access to your risk system.
He’s Able to Manipulate Prices
Central to the NatWest interest rate option mispricing incident was the trader’s ability to pass the implied volatility to the back office for the daily mark-to-market valuations. In one of the two cases of female rogue trading, the dealer passed marks to a supposedly independent sales representative who dutifully reported the inflated prices back to AIB. Same again at Morgan Stanley where the trader was able to manipulate prices and volatilities for credit default swap indices and associated options. And again at the Bank of Montreal where fake valuations were used to cover wrong way bets on natural gas options. And again at NAB where traders prepared schedules containing revaluation rates, which were emailed to third parties. These third parties then emailed the rates back to NAB un-amended. Your perpetrator may be the ultimate source of your ‘independent’ marks.
He’s a Striver
John Ho Park, the 27 year old rich kid who sunk Griffin Trading in 1998, was described as ‘hard-working’ and ‘ambitious’. One of his neighbours reported that he usually left his house before 6 am and wasn’t back until very late in the evening. So too was Leeson, the working class son of a Watford plasterer. The Internet Movie Database plot description of ‘Rogue Trader’, starring Ewan McGregor, begins with ‘one man’s ambition’. And again with Kerviel. A co-worker noted that Kerviel was there when he arrived in the morning and he was there when he left in the evening. Your perpetrator may have an outsized ambition.
Maintaining a fraud takes time and attention. So there is precious little time for vacations, especially when your replacement might take the opportunity to have a look around. Kerviel didn’t take mandatory holiday breaks and he didn’t allow others to monitor his portfolios when he did take time off. He only took four days of vacation in 2007. In a summary of the investigation by the Paris appeals court, he said, “A trader who doesn’t take vacation is a trader who doesn’t want to leave his book to someone else”.’ At Allfirst, Rusnak was issued Travel Bloomberg software so that he could trade from home and while on vacation, a direct violation of US law. Mr. 5% never took a vacation in 10 years. His bosses thought he was dedicated. On the other hand, a Merrill Lynch currency trader learned why time off is to be avoided. His $100 million hole was discovered while he was on a skiing vacation. Your perpetrator might have a particularly good attendance record.
He Made An Error
A small one, mind you, that he only has to cover up for a short period of time while he ‘trades out of it.’ Nick Leeson created an ‘88888’ account to hold a $20,000 error until he figured out what to do with it. Codelco’s massive loss was said to be the end result of a sequence that started with a computer error by the head trader. He bought instead of sold futures on the London Metal Exchange. At MF Global, a trader with no capacity to absorb any loss began overnight trading of wheat futures on 26th February 2008, with a $3,000 hole. The next day his account was closed out at a loss of $141 million. The Common Fund story starts out with a failure to execute the other side of an index arbitrage strategy, the hedge, which caused a $250,000 loss which would fester for 3 years. Your perpetrator might begin his journey to the ‘dark side’ trying to ‘fix’ a relatively small problem.
He Has to Trade Bigger
At China Aviation Oil, short options were carried on the books without time value. When losses were realised on settling options, they had to sell ever more to generate the cash to make good on the expiring options. A similar dynamic played out at Kidder Peabody where the trader discovered a defect in the risk management system. He was able to book illusory profits on a portfolio of US treasury strips versus bonds because the system incorrectly valued forward cash flows as if they were immediately settled. To keep the charade going he had to do more and more to both cover the expiring losers and show additional profits. His position eventually grew to $36 billion. Perhaps Kerviel put it best, “It makes you want to continue, there’s a snowball effect”. Leeson saw the same effect play out in his 88888 account. Your perpetrator’s trading volumes may be rising.
He Becomes a Star
All this success does not go unnoticed. The good times are rolling and no one wants them to end. Mr. 5% was featured in a two page spread in Sumitomo’s 1991 annual report, complete with a laudatory profile and glossy portraits. In it he opined that Sumitomo’s preeminent position in copper trading was due to ‘expertise in risk management.’ He was 5 years into his 10 year run at this point. Within a year of going to Singapore, Leeson had made £10 million, accounting for 10% of Barings’ profit that year. Bank of Montreal’s David Lee was considered a ‘star energy trader’. So too was Natwest’s global head of derivatives. And Calyon’s Bierbaum, before blowing up in 7 months, modestly described himself as the ‘golden child’. Your perpetrator may be a budding celebrity.
And Then He’s Gone
We’ve seen the same patterns play out time and time again over the past few decades. Although the rogue trader has become a clichéd, stock character, he continues to wreak havoc with the same old bag of tricks.
A 13 year old survey by CapGemini found that three quarters of risk managers believed their organisation was immune to a Barings-style scandal. But the same survey found that 85% of traders believed they could hide trades from their managers. With time has come the reveal. History has borne out the traders and reminded us that pride goes before a fall.
By Larry Hickey for Commodities Now [updated for this piece]. Larry is a Senior Manager with Sapient Global Markets. In 1995 he started the first FX options business in Ireland for AIB. The bank was hit by rogue traders in 2001 and 2002