amv October 29, 2012

Kimberly D. Krawiec Duke University

Focus = Basel policy solutions and big cases Current policy − capital set asides based on

internal models − misguided/incomplete

May be no perfect answer

But better answers

Those firms most vulnerable to large rogue trading incident least likely to correctly assess this risk and set aside adequate capital

Instead, it is well run firms – those least

vulnerable to such an incident

Other incentives − e.g. reputation, self-preservation

Healthy institutions likely responsive to those

But institution in stress may not − ripe environment for rogue trading

Jerome Kerviel (Société Générale) Four currency traders (National Australia

Bank − NAB) John Rusnak (Allied Irish Bank − AIB) Joseph Jett (Kidder Peabody) Nick Leeson (Barings) Kweku Adoboli (UBS)

Most recent, least official information

Can we extrapolate from these limited cases, combined with more systematic data, to develop non-financial metrics useful for regulatory purposes?

Improbable profits experience level; performance history; authorized

trading strategy

Unusual trades

Type; volume; Cancelations; settlement procedures; counterparty

Back/middle office issues

Turnover; inexperience; lack of authority

Ignored inquiries from regulators, exchanges, competitors, other employees

Organizational issues

Trading revenues to compensate for shortcomings elsewhere

Delta One, Jan. 2008 revealed USD 7 billion loss

Fraud = series of unauthorized directional positions in equities and equity futures

Concealed by a series of fictitious transactions

Subsequent investigation turned up numerous violations across traders

Back office start

Entry then cancellation of fictitious trades

947 transactions

“matched” trades – i.e. purchase/sale of equal quantities at different “off market” prices, thus generating gain or loss as needed

115 transactions

Intra-monthly provisions

9 transactions

Need to avoid back office confirmation Trades with delayed confirmation dates Examples

pending party names

internal client names

trades with deferred start dates

Common Theme 1 Delayed Settlement Dates

Common Theme 2 Unusual Counterparty Patterns

Impression of low volatility

Common Theme 3 Smoothing − various Forms

Large number of canceled trades

Trades with lag b/w trade and confirm/settlement − e.g. pending party names, internal client names, deferred start dates

Large number of canceled trades

Trades with lag b/w trade and confirm/settlement − e.g. pending party names, internal client names, deferred start dates

Example NAB Group of four currency traders

2001-2004

Losses of AUD 360 million ▪ Not huge amount. But interesting because the whole

desk colluded

Exploited one hour time window between close of trading and beginning of back office checks

Common Theme

Manipulation of VaR, reporting, or computer systems

One of Kerviel’s three techniques Example: John Rusnak (AIB)

Ireland’s second largest bank

Feb 2002 announce losses = $691 million from Baltimore FX trader

Directly manipulated VaR inputs

“Rusnak manipulated the principal measure used by Allfirst and AIB to monitor his trading: Value at Risk (VaR). ….. by directly manipulating the inputs into the calculation of the VaR that were used by an employee in Allfirst’s risk-control group. Thus, while that employee was supposed to independently check the VaR, she relied on a spreadsheet that obtained information from Rusnak’s personal computer and that included figures for so-called ‘holdover’ transactions—entered into after a certain hour toward the end of each day. But these transactions were not real and…. were not even entered on to the bank’s trading software. They were simply a way to manipulate the spreadsheet used to calculate the VaR. A simple check to see if the holdover figures were captured in the next day’s trading activity would have caught this scheme.”

Most egregious case: Joseph Jett

Kidder Peabody, 1991-94

Treasury arbitrage, false profits $264 mil

Actual losses $74.7 million

Ponzi scheme Booked profits on forward recons (a non-cash

trade with no economic significance) Kidder recorded difference between current

price (trading at discount) and forward price as profit

As settlement approached, prices converged and profit disappeared

To Zero

Date Event

July 1991 Hired VP $75K

Total reported profit (7/91-12/91) $787,000

1991 Bonus $5K (negative review)

Oct 1992 Promoted Senior VP

1992 Total Reported Profit $32,481,000

1992 Bonus $2.1 million

Feb 1993 Promoted Head of Gov’t

1993 Total Reported Profit $150,654,000

1993 Bonus $9.3 mill −Kidder “Man of the Year”

Reported Profit 1/94-3/94 $80,100,000

April 1994 Fired

Common Theme 4 Unusual profits/earnings

Esp. considering trader’s prior experience/ record & trading strategy/market

Total year record = $15 million Jett exceeded that in a single month four

times One transaction 1992 − $12.9 Another 1993 − $24.2 By May 1993, Jett’s trading activity = 40-50%

of all recon activity in US 45% of Kidder’s profits

Singapore office Head of settlements and trading Supposed to be following low-risk arbitrage

strategy Quickly abandoned in favor of directional

trades

Fraud initially began with small loss by clerk Created now infamous 88888 to hide the loss He continued to use the account to hide

trading losses Increased size and risk of trades in an effort

to recoup losses Collapsed after Nikkei 225 fell in wake of

Kobe earthquake Sold to ING for GBP 1

1050023ST 27

10 largest net Nikkei 225 futures positions

0 5,000 10,000 15,000 20,000

17.02.95

Barings

Paribas

Salomon

JP Morgan

BNP

SBC

Yamaichi

Soc Gen

Tokyo Mitsubishi

BZW

1050023ST.xls*Osaka Sec

Ex?Chart 2

E.g. Societe Generale

Delta One strong, rapid growth − trading personnel grew from 4 to 23 in 2 years

middle office personnel doubled, but frequent departures and chronically understaffed.

Many were new, undertrained, lacked sufficient experience.

Tolerance of Kerviel’s unauthorized intraday positions − undermined internal control culture

Least information Investigations by UBS and KPMG Enforcement actions UK (FSA) and Swiss

(Finma) authorities Press reports of trial testimony and evidence,

including testimony from KPMG re: investigation

Trader on four person ETF desk Began off-books trading in 2008 Nicknamed “umbrella” (also “Rhianna”) – an

account used as a slush fund to smooth profits and losses

Trail evidence suggests that both Adoboli’s desk supervisor and other traders knew of (and sometimes used) the account

• Adoboli created a short position betting the markets would fall

• masked with a fictitious long position • However, markets rallied following the

austerity measures adopted by Greece. • June 24: reported risk exposure of UBS

=$53m • actual risk = $147m • June 30: reported risk = $41m • actual risk = $1.49bn.

Adoboli changes his view of the markets, becoming more optimistic

Continues to mask real positions with fake trades

July 18: real risk exposure = $4.5bn August 8: UBS real risk exposure = $12bn.

Adoboli again switches outlook, believing

markets will fall uses fictitious ETFs and extended settlement

dates to mask real position risk exposure to UBS ~ $7bn from August 29

until mid-September when the losses are discovered

Losses of $2.3bn after UBS closes out all positions

September 14: UBS discovers unauthorized trades by trader on London ETF desk

September 15: UBS announcement re: unauthorized trading -- anticipated losses ~ USD 2 billion

September 16: Swiss Financial Market Supervisory Authority (FINMA) and the UK Financial Services Authority (FSA) launch independent investigation

September 18: UBS releases more details -- losses ~ USD 2.3 billion; Special Committee formed to conduct independent investigation

September 24: Oswald J. Grubel steps down as Group CEO; Sergio Ermotti appointed Group CEO

October 5: Global Equity co-heads and other staff resign; disciplinary action other Equities staff

October 25: Q3 results announced – SOX control deficiencies identified in submission to US SEC

September 10: criminal trial begins October 26 two additional false accounting

charges applied

Total = 4 false accounting charges and two fraud by abuse of position

John Hughes, a “director level peer” of Mr

Adoboli on the ETF desk, was allocated supervisory level responsibility for the desk.

However, Mr Hughes did not complete

supervisory training despite being asked to do so 17 times by UBS compliance.

“There is strong evidence of collusion at local

desk level [that] undermined this key control”.

The “local supervisor [Hughes] was aware of

Mr Adoboli’s propensity to smooth the profit and loss and take unacceptably high levels of net delta [risk]”.

When asked why he did not report Adoboli to the bank: “Because I’m stupid. I should have reported him. Still to this day, I wish I had done. Then we wouldn’t be here.”

March 2011 supervisor John Hughes to Adoboli: “Your umbrella is going to get us all fired”

August 16, 2011: John Bennie, a senior UBS trader, with John Hughes Hughes mentions client positions that “were not even

visible to the rest of the floor” Bennie: “So the muppets think everything is zero

whilst the experts trade.” Hughes testifies in court that “muppets” referred to

UBS management.

Darren Bailey (fellow trader) email to Adoboli: “Have you used the slush account?”

Bailey also testified that he asked Adoboli to “warehouse” trades of between $1.2m and $1.5m for him

Bailey was reprimanded and banned from trading futures for three months

Christophe Bertrand (former ETF trader with Adoboli) testified that Adoboli told him of the umbrella fund in early 2011

Claims he misunderstood the fund’s purpose

Many more

UBS system for flagging extended trades with settlement periods longer than 14 days -- and calling their counterparties for verification -- stopped functioning and was reinstated after Adoboli was arrested last year

Adoboli booked fakes trades with extended settlement dates, giving him time to cancel them

Adoboli booked internal futures trades to avoid providing price details

back- office accountant at UBS Began questioning Adoboli’s trades in early

August 2011 after being alerted by a “break” of $3.57bn – where the books did not balance.

Adoboli explanation: he had booked internal future trades rather than exchange traded funds because he was “very busy”

Steward “if he booked the correct trades, they would be seen by the outside world and he’d spend a lot more time calculating the price and have to book a lot more detail than internal trades”.

“This was a temporary solution where he was short of time to make the books look balanced and eventually put the right trade in,”

Not efficient, as regulatory matter, to bring risk of rogue trading to zero

Focus on “systemic” cases − i.e. those with potential to cause firm failure and market disruption

Lessons from outlier cases is thus warranted

Need clear metrics that regulators can

monitor Ideally, metrics that those reporting have no

incentive to manipulate Current financial metrics (e.g. AMA)

problematic for these cases, because inputs manipulated and not caught

ratio of back to front-office personnel Back and middle-office turnover, training, or

experience measures Percentage of trades with delayed

settlement/confirm Canceled trades ratios Counterparty verification Percentage of illiquid trades (difficult to price) percentage of employee incentive-based

compensation