Rogue Traders

As the last of the City bonuses are paid in January, the inevitable comparisons are once again being made between traders as to whether their bonus sufficiently recognises their contribution to their respective firms.

In the Western financial world, the end-of-year bonus always sparks debate as to whether traders genuinely deserve the additional bonus on their salaries. But, it is all too easy to forget the stress and risks associated with running money.

Being on the wrong end of a market movement is infuriating, and it can be tempting to chase losses without formulating a recovery strategy. Nowhere could this have been better illustrated in recent years than in the case of Kweku Adoboli – an equities trader sent to prison for seven years for fraud.

In addition to manipulating official safety systems designed to hedge against losses at his Swiss bank employer UBS, Adoboli had become addicted to careless speculation outside of work.

He started spreadbetting riskily with his own cash too, leading to a reliance on payday loan companies to meet his outgoings, despite earning over £350,000 a year. His ‘gambling’ addiction – as labelled by the judge in the recent case – resulted in a £2.3 billion loss for UBS and prison sentence for Adoboli of which he must now serve half. There was also a sizable fine from the regulator.

UBS: The Fallout

UBS was slapped with a £29.7 million fine by the Financial Conduct Authority (FCA) towards the end of 2012 as a direct result of its compliance and regulatory failings relating to rogue trader Kweku Adoboli. The fine was reduced from £42.4 million because UBS agreed to settle early without disputing the fine.

On 14 September 2011 UBS became aware that unauthorised trading had been carried out between 1 June 2011 and 14 September 2011 on its exchange-traded products desk within its Global Synthetic Equities (GSE) trading division in London.

The Financial Conduct Authority ruled that the systems and controls failings revealed serious weaknesses in the firm’s procedures, management systems and internal controls, led to massive losses for the bank. The losses were incurred predominantly on exchange traded index future positions. The underlying positions were disguised by the use of late bookings of real trades, booking fictitious trades to internal accounts and the use of fictitious deferred settlement trades.

In its statement to the market, the FCA said UBS failed to take “reasonable care” to “organise and control its affairs responsibly and effectively”. Adjudicators at the regulator added that risk management systems were inadequate and failed to ensure activities were conducted with due skill, care and diligence.

Tracey McDermott, director of enforcement and financial crime at the FCA said the bank’s systems and controls were seriously defective. She said: “UBS failed to question the increasing revenue of the desk and failed to ensure that there was a corresponding increase in the controls in place over the desk.

“As a result Adoboli, a relatively junior trader, was allowed to take vast and risky market positions, and UBS failed to manage the risks around that properly”.

“We know from past experience that failures to manage risk properly can cause firms to fail and cause systemic harm. It is imperative that the markets we regulate are seen by investors to be orderly and a safe place to do business.” The FCA added that the penalty was fixed at 15% of the revenue of the GSE trading division – to make it clear that the regulator expects much higher standards from the industry as a whole.

The Adoboli case was preceded by an appeal case by French rogue trader Jérôme Kerviel in October 2012. Like Adoboli, Kerviel was found to have used fraudulent methods to conduct rogue trades which left French bank Societe Generale on the edge when his trades were discovered in January 2008.

Having originally been sentenced in October 2010 to a minimum of three years in prison, Kerviel appealed against his sentence and the order for him to repay €4.9 billion, claiming the bank knew of the trades he had previously placed and were unconcerned when the bank was making money in 2007 and 2008. He also claimed that the bank had tried to disguise its own losses from the US sub-prime crisis by using him as a scapegoat.

From an institutional perspective, the compliance managers that are paid to monitor their traders could certainly learn a lot from the recent case.

When rogue traders have gone on trial, it is sometimes highlighted that their understanding of how to bypass controls comes from experience in a nonfront office role – Joe Bond, Vice President of Trading, Abshire Smith

Joe Bond, vice president of trading at stockbroker Abshire Smith, says there needs to be clear lines of responsibility for individual positions to remove the temptation for manipulation or fraud. He explains: “Risk managers need to be able to access all live accounts to view live positions rather than just reports that could be altered. The compliance & risk function also need to have the knowledge of the trader’s products to quantify the potential risks.

“A recent survey suggested that less than 50% of derivatives processing is automated. This lack of STP processing is due to the complexity of trades. It is estimated that up to 30% of OTC derivative trade confirmations contain an errors and require subsequent handling for amendment.”

Bond says the reason that rogue traders continue to hit the headlines is that companies remain reluctant to spend on technology. He says: “The monitoring systems for derivatives that are being developed are expensive, but will potentially reduce the potential for so-called rogue traders. However, one point of note is that many front office roles are filled from middle and back office.

“When rogue traders have gone on trial, it is sometimes highlighted that their understanding of how to bypass controls comes from experience in non-front office roles.”

Like most familiar with trading, Bond stresses that derivatives are not an evil, but acknowledges that leverage and minimal margins do enable phenomenal losses. He says: “I heard Nick Leeson speak last year and he did seem genuinely guilty for what happened. But it was clear at the time of his actions, the markets and management’s hunt for profit had evolved further faster than its systems and controls.”

Leeson is arguably the most famous rogue trader of all time. Watford-born Leeson joined Barings in 1989, having spent stints at Coutts and Morgan Stanley prior to that.

But it was in 1992, when Barings was seeking a talented trader to move to Singapore to take up their position on the Singapore International Monetary Exchange (SIMEX) that Leeson would be unleashed.

Initially, Leeson had performed well after moving to Singapore. His first year there contributed around £10 million to Barings’ annual income and he as incentivised accordingly, reported taking home a bonus of £130,000 on top of a £50,000 salary.

However, things started to unravel after he used an account established for trading errors to cover a loss that a junior colleague of his had made. The loss of around £20,000 was successfully covered initially, but Leeson would later use the same error account to rack up massive losses from unauthorised trades of his own.

Once again, the compliance systems, checks and balances were called into question at the now defunct Barings Bank as Leeson was permitted to settle his own trades while continuing as chief trader – something traditionally completed by two separate individuals.

By the end of 1994, the losses on the unchecked account had soared to £208 million, prompting Leeson to make one final gamble on 16 January 1995 when he
employed an options trading strategy known as a ‘short straddle’ to bet that the Singapore and Tokyo exchanges would remain static overnight.

And he might have got away with it, were it not for the Great Hanshin earthquake which heaped further serious losses on Leeson. Further trades he made trying to recover the position failed and he eventually racked up losses of £827 million by the time he fled on 23 February 1995. Barings Bank itself would later be declared insolvent as a direct result of Leeson’s trades.

Despite the actions of Kerviel, Leeson and Adoboli, it should be remembered that billions of people trade worldwide every day, many with their own personal accounts. It must be assumed therefore that trading is safe for the huge majority. However, the points of interest from the reflective minds of rogue traders of the past show there are lessons to be learnt from individual traders and companies alike.