In the news It appears that little was learned from the

The world of Rogue Trading

Firm Morgan Stanley x2 , Aracruz, Citic Pacific, Deutsche Bank, Sadi, MF Global Date 2008 Multiple rogue trading events which drive industry losses on mass

Author Martin Davies | 17th September 2011

Firm Date Trader Event Market Loss

Firm National Australia Bank Date 2003—2004 Trader Gianna Gray, David Bullen, Vince Facarra Event Control Override Market FX Options Loss AUD 360 Million

Barings Bank 1995 Nick Leeson Authority Conflict Nikkei Futures GBP 827 Million

1995

Firm Daiwa Bank Date 1984—1995 Trader Toshihide Iguchi Event Loss Concealing Market US Treasuries Loss USD 1 Billion

2002

2004

2006

2008

Firm Allied Irish Banks Date 2003—2004 Trader John Rusnak Event Fictitious Revenue Market FX Options Loss GBP 691 Million

Firm Date Trader Event Market Loss

Sumitomo Corporation 1996 Yasuo Hamanaka Market Manipulation Commodities Market USD 2.6 Billion

Firm China Aviation Oil Date 2004 Trader Chen Jiulin Event Authority Conflict Market Commodities Futures Loss USD 550 Million

société générale 2006-2008 Jérôme Kerviel False Hedges Stock Futures EUR 4.9 Billion

Firm Date Trader Event Market Loss

Rogue trading takes on many shapes and forms although the underlying motive is usually driven by pride, greed or desperation. In the case of pride, a trader fears to be beaten by the market, a place that directly questions their ability or more so, their credibility as a trader. In a dangerous move to save face, the trader increases their position taking behaviour in the hope that a quick turnaround of the market will save all, including most importantly respect from their peers. This is akin to the gambler who believes his luck must eventually change and there is nothing illegal with this kind of thinking as long as the trader doesn’t attempt to conceal the positions they are taking. That is the line which must not be crossed. In the Barings Bank case, Nick Leeson had the authority to increase his limit without raising concern because he was not only the risk taker but also involved in settlement. This is a fundamental policy design flaw for a bank and most institutions have already closed this loop hole by erecting Chinese walls between the traders, risk and middle office.

2010 2011

Firm Date Trader Event Market Loss

Jerome Kerviel Société Générale rogue trading event. This time however, it is UBS that is attempting to explain to shareholders why it has fallen into the same trap of failing to identify fictitious trades on its books.

Firm Date Trader Event Market Loss

Groupe Caisse d'Epargne 2008 Boris Picano-Nacci Systemic Control Failure Equity Derivatives EUR 751 Million

UBS 2011 Kweku Adoboli False Hedges Equity Derivatives USD 2.3 Billion

The National Australia Bank episode was different and FX traders turned off controls by misreporting however, unfortunately for the NAB team a whistle blower brought the game to an end. Quite tragic actually; a week after the regulator walked in and closed the desk, the traders were on the hook and televised in Technicolor for all to see. The CEO was pulling coffees in the lobby and the markets swung into the favour of all of those involved yet, too late for any accounting vindication to be effective. Booking fake hedges however is a more elegant way of pretending to reduce risk in what appears to everyone away from the trading floor as a transparent and business as usual response to overly deep positions.

Continued on p2 http://causalcapital.blogspot.com

Research & Reading — Causal Capital | draft paper for release

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So why does a trader do this? Well the fake hedge buys the trader time, enough time in their minds to clean up the mess. The exposure on the book looks flatter when reported to risk management because opposite hedges are theoretically offsetting the real hazard. In effect, the trader can profit from the original trading strategy as flawed as that may be, net off the squared hedges and all will be fine. All they need to do is a little bit of explaining to compliance and everyone goes back to their knitting. Critically if these guys are in the money at the end of the day they have the unwritten right to skew the book. No one criticises the golden head boy, the buccaneer who has made all the pecuniary gain and in banks the same rule applies. To push us further into the immoral domain, this very nature of winner takes all is likely to be celebrated with Champaign, lots of bling and I am sure some rogue traders out there have fleeting moments of grandiose proportions where they see themselves advance to king of the bidding pool, taking home employee of the year and a testosterone fed fantasy of being most desired from those they secretly admire.

Deterioration of Trading Standards

10 9 8 7 6 5 4 3 2 1 0 1974 1987 1993 1994 1995 1996 1997 1998 2000 2001 2002 2004 2005 2006 2007 2008 2010 2011

Of course these fake hedges are never settled as the rogue trader will square them off before delivery.

Figure 1 : Average event loss and event count

By looking at the data, one would be left to believe that rogue trading is on the increase however statistically speaking that isn’t really supported. On average there has been one large rogue trading event each year from 1974. Rogue trading in this essence appears to be a continuous activity which is exposed during periods when the markets are most volatile. The huge spike in rogue trading events during 2008 were in many cases the result of risky positions being marked down as the financial crisis collapsed prices, many of these rogue traders would have never been exposed if the market had remained solid. To quote Warren Buffet “It's only when the tide goes out that you learn who's been swimming naked.”

This very nature of stubborn defence of ones beliefs by going deeper on a gamble is a human failing and nearly all us suffer from it to some degree or another. Let me put it to you; if you have ever argued a point to voice raising proportions or failed to appreciate a dilemma from another angle only to find out later that you weren’t quite right, then you too have met some of the psychological criteria needed to be a rogue trader. I personally don’t blame the traders for their human flaws, I question the viability of risk, control, audit and governance of these banks. Traders are like an army, equally important but dangerous as mercenaries an army is, the rogue trader is an equivalent nuisance in the dealing room.

Continued on p3

Figure 2 : The Rogue Trade Roll | http://en.wikipedia.org/wiki/List_of_trading_losses [The list is a sample and not complete]

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Driving Factors So what can banks do to reduce this recurring catastrophe? I have taken to list some of activities here that can be considered by risk and control of these banks to put rogue traders in the corner and, well before they do any real harm. Clearly one oversight is to stop measuring risk in silos, bring the futures book into the counterparty risk reporting service and put an end to off system trade bookings. The next point is to ensure that all deal taking is monitored with rogue trading in mind, very large notional positions on a prop desk need to be reviewed even if they appear hedged. One of the biggest flaws with risk departments is that they don’t specialise or understand the varying nature of different trading desks that are facing them. Both in the Société Générale and UBS rogue trading disasters, the losses originated from the Delta One trading desks, minus the real hedges of course. Delta One trading is part of the equity finance team of an investment bank that offers products that may have no optionality but which have a delta to one for a given percentage point move in the underlying asset. Sample instruments traded on these desks include Exchange Traded Funds, Equity Swaps, Baskets, Futures, Forwards and often deals involve dividend trading as well as index arbitrage strategies. Delta One trading is hot business for many investment banks although it isn’t particularly nouveau. It is a market making activity feeding from and to the retail sector in some degree and which in many cases is tightly aligned to prime brokerage. It is akin to the world of repo’s in that it is a flow type domain with securities lending or funding with a prop angle. The prop angle on the Delta One desk often comes in the form of higher returns from more effectively managed hedges coupled with high frequency trading. When dividends are being swapped a stocks price position may not even be that critical for measuring risk in a deal. Is this convoluted trading, not really. The exotic rates desk is probably more scary from a mathematical point of view however the varying nature of these evolved equity instruments will often result in multiple system bookings for a single portfolio and an inconsistent aggregation point for exposure measurement in the counterparty and market risk systems. Banks need to improve their risk reporting systems to capture this exposure which can be transitory in many cases and I know of several institutions not including UBS that have no grasp on the outcome of the Delta One trading crew. One counterparty risk analyst whom I won’t name out of pure kindness although, they deserve less, tried to explain to a group of people on a conference call I was sitting on that cash equities was risky business. I would honestly question whether they actually know whether Delta One Trading even exists seeing that they know less about equities than your average fellow. While that wasn’t a shock to me, the fact that too many other analysts on that telephone call agreed to this ridiculous statement, says to me that risk people aren’t in touch with the front line.

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[a] Many of the large international banks have extremely complex booking models which can encompass multiple systems and more often than not, include back-to-back trade sets across more than one jurisdiction. [b] In addition, banks are increasingly entertaining highly structured trading practices to either differentiate their business models or to take advantage of relative tax and regulatory incentives between cross boarder subsidiaries. This increases complexity & heightens the need for clear documentation on trading practices & limit application policy.

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Risk, Control & Audit needs to be carry out specific exercises:  Reduce silo based monitoring of exposure. A grainy picture of trading activity is established by reviewing both counterparty, market, wrong way risk— inline with risk taking actions.  Monitor changes to leverage / notional amounts on desks.  Track trades with breaks, cancellations, restructures or overwrites. Review late trade bookings & off system deals.  Separation of duties, review of changes to margin depth & instil doubling policies.

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Rogue trading generally has behavioural aspects within in it:  Teams in competitive environments that are on profit making positions such as prop desks need continual monitoring.  Limits for profit making books need daily reporting, changes to headroom or one sided concentrations need tracking.  Construct a reporting process for monitoring net positions of traders books, including hedges and adjustments.  Changes to trading strategies need flagging & authorisation.

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Dashboard like continual monitoring:  Continual reporting of exposure both actual & stress tested.  Authority for large books or deals need to be captured.  Risk appetite definitions need to track approval processes.  Breaches of VaR limits need explanation and write up to senior management. Frequency of breaches need tracking. These are only some of the activities, more work is required.

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