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An insider’s guide to rogue trading

An insider’s guide to rogue trading
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First Published: Wed, Oct 26 2011. 01 15 AM IST

Nick Leeson
Nick Leeson
Updated: Fri, Oct 28 2011. 07 36 PM IST
The credit crisis and its aftermath, the European sovereign debt crisis, have ruined a generation of bankers who have entered the industry in the last five years. The closest they’ll ever get to seeing big bonuses is when reading about them in Michael Lewis’ books. However, for traders and aspiring traders who joined the industry for the noble purpose of helping others see Ferraris, Patek Philippes and luxury penthouses, all is not lost. Here is a simple, five-step process to teach the aspiring trader to play their cards right and unleash the inner rogue.
Step 1
Nick Leeson
The first step is to choose a tier II or tier III bank with pretensions of becoming the next Goldman Sachs. Almost all potential candidates trip at this first hurdle and consign themselves to a life of upper-middleclass drudgery. Ironic, since traders set great store in being contrarian. The reason for such a choice is simple: these wannabe banks have poor systems to monitor risk, with a mish-mash of cheap, off-theshelf software and ad-hoc, internally developed VB spreadsheets just about passing regulatory muster. Add in management mediocrity in an organization with its strict adherence to the Peter Principle and our aspiring trader feels like the Wehrmacht encountering Polish resistance. In contrast, a tier I bank will disable their pass and issue an all-points bulletin even before they reach the parking lot after misbooking a piddling $10 million trade.
Step 2
The next step is to choose to trade either in a liquid exchange-traded market or a completely opaque complex derivative book, which requires multiple-model inputs as it successfully evades the small number of effective risk controls in place. The historical bias has been for the former simply tier I banks are similar; each wannabe bank is deficient in its own way.” A quick look at history will justify this famous quote: Nick Leeson used a hidden account for his rogue trades, Adoboli apparently used deficiencies in monitoring forex exposure, and Kerviel used Frenchmanagers’ assumption of omniscience. because first, tier II and III banks don’t have big enough books to lose enough money on complex derivatives and, second, the entry requirements are tougher with a master’s or PhD required to trade. After the disservice done to traders by the media’s portrayal of them as reckless gamblers and its confirmation by traders’ antics, banks have managed to create a Maginot Line covering the semi-liquid markets such as corporate bonds. The undefended positions in the very liquid exchange-traded market are due to the management belief that it is impossible to hide positions or price incorrectly. In complex opaque markets, the management has no idea about the product and defers to the trader as long as his profit and loss statement is in black and he can answer any question on pricing with a sufficiently overly complicated argument using triple integrals.
Step 3
Top of the class: (from left) Yasuo Hamanaka, Kweku Adoboli and Jerome Kerviel.
The third step is to befriend everyone in IT, product control and risk management. This was easier when traders rose from the ranks, but Kweku Adoboli of UBS and Jerome Kerviel of Société Générale have erected a class barrier. However, the aspiring trader must reach across the divide as not only will it help in understanding the system and risk control process deficiencies, but also give an early warning in case the rogue trade is unravelling since the product controller friend is likely to ask the trader to confirm discrepancies before going to the boss. As Leo Tolstoy might have said today, ‘‘All tier I banks are similar; each wannabe bank is deficient in its own way.” A quick look at history will justify this famous quote: Nick Leeson used a hidden account for his rogue trades, Adoboli apparently used deficiencies in monitoring forex exposure, and Kerviel used French managers’ assumption of omniscience.
Step 4
Now that the preparation is done, pacts are made, onward to the fourth step: initiating the rogue trade through gradually increasing the long position in the traded asset. Rogue trades, almost by definition, are on the long side, primarily due to two reasons. The first being that long-risk positions benefit from the behavioural quirk of being perceived as ‘‘natural” and, hence, lower risk with the positive carry providing daily confirmation of this erroneous belief. A short-risk position, in contrast, requires an explanation for the daily carry cost, which increases with position size leading to detection before optimal size is reached. The second is the lower number of operational issues such as repo, stock borrow, etc., associated with long positions reducing the probability of early detection. A gradual increase in position size is recommended as the increased time to attain rogue status allows unknown unknowns to appear at a pace that can be dealt with successfully. The hall of fame is testament to the fact that patience is a virtue: Yasuo Hamanaka, Leeson, Kerviel, Adoboli all built their gigantic long positions over time.
Step 5
The fifth step is the most difficult with even those in the hall of fame unable to execute it successfully. It involves cashing in on the rogue trade irrespective of the outcome of the trade for the bank. Usually, the rogue trade fluctuates between a large gain and a large loss as the trader becomes mesmerized by the roulette wheel and forgets that the aim of the game is to walk out of the casino floor with a suitcase full of chips. Eventually, the large loss is discovered and Christmas comes early for readers of The Guardian. A large loss is obviously a problem, but a large gain on the rogue trade is a problem as well. This is mainly due to two reasons. The first is the way bank compensation works where gains beyond a small absolute amount are earmarked for the management bonus pool. Marx was so enraged by this that he wrote pages and pages on the expropriation of the value added by labour. The second is that large profits also raise red flags and, often, it is not easy to realize the mark-to-market gain and hide the cash. Therefore, the trader is advised to follow a simple three-step process to reap the rewards of his hard work.
1. Set up a personal trading account, which cannot be traced back easily, preferably in a jurisdiction where access to money is easy, extradition is not.
2. Take the opposite position in this account. In case of a gain on the rogue trade, use the rogue position and profit to push the market the other way and gain on personal account until the large profit reduces to a more manageable size, which can be reported to further trading career within the bank. This cycle can be repeated until one is unfortunate enough to chalk up a large loss.
3. When detection becomes inevitable, the trader needs to catch the first available flight to the destination of his personal account and not ask his Facebook friends to pray for a miracle. The bank’s forced unwind of the position will ensure the personal account is topped up nicely. Once safely ensconced in a penthouse with a sea view, he can profusely apologize for his trades, deny criminal intent, and state that he had the best interests of the bank at heart. Then he should concentrate on the more important work of securing a large advance for the book, selling the movie rights, setting up a lecture tour (in non-extraditing countries only) and offering expertise in risk management and fraud detection to banks.
Photographs: AFP, Bloomberg
Su Do Nim is a sceptical investment banker based in London. He wished to remain anonymous, while his blood funnel sucks the life out of the global financial markets. And your savings.
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First Published: Wed, Oct 26 2011. 01 15 AM IST