STRATEGY
The dangers inherent in the world of securities and derivatives trading have risen dramatically. This new threat is a result of the advent of high-frequency,
‘black box’ trading strategies, and fully automated, low latency exchange markets. In the past, traders would exceed limits, and finding prices moving against them, extend their unauthorised positions. The buildup of risk and losses would force the individual to cover up and misrepresent activities. Such hidden positions, when brought to light, have toppled banks, and led to resignations of senior executives with otherwise stellar records. In the future, banks, or worse
— clearing houses — could be brought down by high-frequency trading software building massive positions in unforeseen and difficult to predict ways.
The future black box rogue trading scandal will have much in common with prior rogue trader scandals. The actions of those individuals dubbed
‘rogue traders’ have fascinated and, to an extent, invoked a degree of awe and admiration from those not directly affected by their machinations. These individuals circumvented controls, exceeded limits, and carried on by misrepresenting their holdings and risk.
Traders ordinarily buy and sell financial instruments with the goal of making profits each time they trade them.
Those who are good at what they do can bring the firms for which they work enormous profits — and, in turn, earn large salaries and bonuses. But there are risks involved and traders can also end up on the loss side of the equation.
Unfortunately, in the high-stakes, high-risk, high-tension world in which traders find themselves, the drive for success can overcome ethics. These individuals cover losses and deceive their colleagues, often in clever and
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high frequency trAding ThE GRoWING ThREAT of RoGUE TRAdING ingenious ways. The result is the so-called rogue trader: people like
Jérôme Kerviel at Société Générale and Nick Leeson of Barings Bank, who managed to hide their losses over extended periods by stealth and misrepresentation until their houses of cards tumbled and the spectacular frauds they perpetrated came to light.
With just these two rogue traders, the money involved is almost incomprehensible: Kerviel’s actions
(revealed in 2008) cost Société
Générale, France’s second biggest bank, some $7.1 billion. Leeson, who brought down the 233-yearold Barings Bank almost a decade earlier, did so at a cost to the bank of about a third of that amount.
Interestingly enough, instead of invoking public scorn and rage,
Kerviel was looked upon by some as a hero because he (to his fans) outwitted fat-cat bankers. Leeson was seen as the inevitable result of blue-blooded bankers unprepared for the new, roughand-tumble world of global finance.
The very use of the word rogue (which has long been synonymous with words such as scamp , scoundrel or rascal ) raises a number of interesting questions when it’s paired with trader . Why do these individuals receive jail sentences well under ten years for their deeds?
After all, many bank robbers — notably those who use just a note asking for money, are unarmed and on average make off with $4,000 — tend to receive sentences that are double that. Is it the very daring of these traders, their seeming success at fooling so many people in charge of these institutions, that attracts wide public attraction
(and perhaps admiration)? Why do rogue traders have movies made about their crimes, sign enriching book deals and go on to successfully reinvent themselves once they are released from their comparatively short prison terms?
A closer look at rogue traders
Examining the lives of the most prominent of the rogue traders reveals some common characteristics that could be used by those in charge of financial institutions to flag individuals whose actions may warrant closer supervision.
– They tend to have less than stellar credentials or educational backgrounds, but a strong drive to succeed. This would serve as a good description of Nick Leeson, www.london.edu/bsr BUSINESS STRATEGY REVIEW 51

STRATEGY who according to the BBC, was
“a working class lad from Watford, the son of a plasterer, [who] was chuffed to land a job in the purportedly glamorous world of the
City of London in 1982…. It was a relatively low-grade job, but he quickly made a name for himself.
He worked his way up, becoming a whiz-kid in the hardworking atmosphere of the far-eastern currency markets.” Kerviel was described by The Economist as ‘a country bumpkin from Brittany’.
Yet, he was a country bumpkin with an appetite to trade billions although his remit required him to fully hedge his positions.
– They are more interested in being seen as heavy hitters or successful traders among their peers than they aspire to accumulate massive wealth. Leeson, interviewed by the
BBC about the actions of Kerviel, explained, “Probably his biggest fear was the fear of failure, as was mine…. Everything gets caught up in the success story around you.” Moreover, the investigations quickly showed that Leeson and Kerviel made no personal profits from rogue trading.
– They seem to be especially good at winning the confidence of those above and below them in their firms’ hierarchies. Influence and
‘star status’ gives them the latitude and permission to circumvent standard practices and be granted exceptions. For example, according to The New York Times , John
Rusnak of Allfirst Financial of
Baltimore, a subsidiary of Allied
Irish, who in 2002 was exposed for hiding losses of $691 million over five years, was allowed to
‘trade during his vacations, which is against banking guidelines because scams are often discovered during a break in trading’ when colleagues spot discrepancies.
– They have an above-average understanding of the back-office systems for mundane tasks like trade confirmations and margining, knowledge that allows them to manipulate data to cover their tracks. According to the BBC,
“Société Générale alleges the trader
[Kerviel] used in-depth knowledge of the control procedures gained while working in the bank’s middle office in his former job.”
How they do it
After the blow-up, it usually turns out that rogue traders have exploited multiple weaknesses in their firms’ procedures and systems. Keep in mind as well, that in most cases, investigations reveal that any number of managers were aware of profits
(which later, of course, turn out to be fictitious), and therefore that risks were being taken. The performance culture of banks however, pressurises senior management to turn a somewhat blind eye to what is going on. The hope is that the results will enhance bonuses and promotion opportunities.
It is notable that these events occur rarely in firms (e.g., ‘bulge bracket players’) that are regarded as having stronger managements, teamwork cultures and more tightly controlled market operations. Top banks avoid giving any individual broad authority to make both trades and entries into back-office systems.
Joseph Jett at Kidder Peabody in 1993 was an unusual case, since he worked for a leading Wall Street firm at the time; however, the firm’s own systems were miscalculating profits for fixed-income positions.
Jett merely made trades that Kidder’s own systems said were profitable, when in fact they were not.
‘Joseph Jett was head of government bond trading at Kidder Peabody when in 1993, he was abruptly fired — and blamed for generating losses that resulted in a $210 million write-off for Kidder’s parent, General Electric.
Both the Securities & Exchange
Commission and the National
Association of Securities Dealers rejected Kidder’s charges that Jett had engaged in fraud. But the SEC charged him with book- and record-keeping violations as well as intent to commit fraud and ordered him to disgorge
$8.2 million in alleged false profits.’
Leeson and Rusnak, on the other hand, overrode standard procedures by allowing large trading positions to be built up without adequate counterparty confirmations. They both were able to manipulate risk management reports to convey the false impressions that any losing positions were hedged by profitable ones (Rusnak), or that the losing positions belonged to customers (Leeson). They also were able to limit or prevent any external pricing validation (mark-to-market) of their positions to take place.
An ounce of prevention
The major rogue trading cases were all avoidable through basic, general management. There are a few immutable principles in the control of trading operations, but management must enforce them rigorously and continuously with no exceptions.
The four core principles for avoiding rogue trading disasters are as follows.
1 Separating front/middle/back office activities and processes
— Segregation of duties ensures traders cannot interfere with the processing and reporting of their transactions
2 Limiting access to trading, risk control and settlement systems to separate functional areas completely and preventing any individual from having access to more than one area
3 Using independent, outside pricing sources for mark-to-market valuing of positions — it’s easy to value a bank’s position in IBM shares, but many traded instruments do not have an easily obtained market price. Allowing internal staff to enter price estimates for profit and loss calculations opens the firm to deception
4 Ensuring integrity, which is the key to a good trading system — this means all trade accounting data are accurate and consistent, and can be verified easily through reconciliation with external parties (e.g., client trade confirmations, clearing)
In sum, firms must maintain a robust control environment, allow for audits, limit access to key functions to specified users, and be able to reconcile with other internal and external data.
Rogues to the nth power
Until recently, traders who hid risks day after day were the main concern.
Paper trade tickets stuffed in a drawer or error accounts were the means rogue traders used to cover their losses.
Today, sophisticated market technology allows orders to be placed and trades to be made with mere milliseconds of delay. Have banks’ internal controls been adapted and made tougher to handle this new environment?
‘Fat-finger’ errors from misentry of data or an extra digit added to the quantity field remain common, and are difficult to prevent. While leading firms have strong controls capable of detecting and closing off trading activities that exceed limits, I fear
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high frequency trAding ThE GRoWING ThREAT of RoGUE TRAdING other firms active in today’s markets could find their software building large loss-making positions in unforeseen ways and without real-time detection.
The rising concern today is about traders developing black box programs or algorithms that run amok or ‘go rogue’ when triggered by certain conditions. The speed and volumes in today’s markets mean ‘algos’ can do their damage in an extraordinarily short period of time. In the past, forged paperwork was often behind trading frauds; but this is less of a risk in today’s computerised age, when high-frequency traders are dominating the equity market. According to the
Financial Times , these traders now generate more than 60 per cent of the volume of trades because they are capable, collectively, of executing billions of shares a day. Moreover, it also notes that, according to regulators,
“it is unclear who is monitoring traders to ensure they do not take undue risks with their algorithms.”
Other unanswered questions include:
– Are banks running ‘stress tests’ on their high frequency trading programs?
– Could errors in price feeds from the many sources of market data trigger a flood of trades before the aberration is detected?
– Could detailed knowledge of a large bank’s algo trading rules be exploited by an external trader who sets off the market conditions that lead the algo to
‘misbehave’ or ‘go rogue’?
– Are regulatory cross-market
‘circuit breakers’ and trading halts required, or can natural price discovery be retained in today’s low-latency markets?
Concern about the role of these algorithms skyrocketed after the so-called ‘flash crash’ of 6 May
2010 that caused the Dow Jones
Industrial Average to plunge nearly
1,000 points in less than a half hour, with nearly a trillion dollars in stock market value evaporating — and then
(mysteriously) reappearing. When it was later discovered that 68 per cent of the questionable trades that ended up being cancelled involved
Exchange-Traded Funds (ETFs), whose trading is highly computerised, the US regulators decided to explore whether algorithms that cause disruption in markets should be treated as if they were rogue traders.
Regulators are eager to develop methods for assigning responsibility when trading technology goes awry. Overall, the computerisation of financial markets has improved transparency and efficiency, and reduced investors’ costs. To avoid politically-motivated bans on new trading technologies, leaders in the financial markets industry must define when high-frequency or algorithmic trading crosses the line into being disruptive to markets, and who is responsible when it happens.
Finding the answers to these concerns is now perhaps the most critical element in ensuring the safety of financial systems in the future.
The next rogue trading scandal will not lead to front-page photos of a disgraced individual. It will centre on lines of programming code gone awry, and the inevitable realisation that a bank’s management failed to control high frequency trading risks before it was too late.
The auThor
BRUCE WEBER
BWEBER@LOnDOn.EDU
Weber is professor of Information management, and Subject
Area Chair for management
Science & Operations, at
London Business School.
www.london.edu/bsr BUSINESS STRATEGY REVIEW 53