Rogue Trading: Controlling the risk 

Rogue traders have always existed in one form or another. The combination of breach of faith, betrayal of trust and deception is common to most areas of financial crime. What tends to mark out the contemporary rogue trader is a particular set of circumstances and characteristics:

• the individual involved is normally not motivated by personal greed, at least directly
• his deception starts small but spirals out of control
• the sums involved can reach astronomical proportions.

It is unsurprising that the actions of such individuals hit the headlines. Among the most notorious instances in recent years:

• Kweku Adoboli is alleged to have caused UBS to lose $2.3 billion trading on market futures in 2011.
• Jérôme Kerviel lost Société Générale €4.9 billion over three years to 2008, again as a result of trading stock market futures.
• Brian Hunter lost $6.5 billion for Amaranth Advisors in 2006, trading on natural gas futures.
• Perhaps most famously, Nick Leeson brought about a loss of £827 million, and caused the collapse of Barings Bank after 233 years of existence, through his trading on the Nikkei Index.

Such stories receive sensational media coverage, and it is always dramatic to depict a single individual being responsible for such catastrophic consequences. However, the real reasons behind, and causes of, rogue trading are more complex. It is these features which companies need to understand if they are to institute effective controls.

The first key point to note is that no company is immune. Wherever large sums of money flow through large institutions, there will always be the potential for rogue trading to emerge. Constant vigilance and defense in depth are essential. Furthermore, it is usually not the most high-profile, complex or apparently risky areas of activity which are most susceptible. The majority of rogue trading occurs in comparatively humdrum or presumed safe parts of the business, out of the spotlight. Problems can start small but rapidly escalate to threaten the whole firm.

There are also a number of institutional and individual features which contribute to rogue trading. These are the subject of increasing debate in the industry. It is perhaps a cliché to point to the excessive risk-taking mentality and aggressiveness of mainly-young, mainly male traders. But there is no doubt that there is a tendency for companies to hire as traders people who tend to be more prone to such activity. When traders are speculating with other peoples’ money, the need for external controls is clear.

Secondly, a corporate culture which encourages (acceptable) risk-taking can easily become one where excessive risk-taking is tolerated, or where those involved become blind to it. When trades which push the bounds of what is permissible come off, and the firm makes a large profit, there is an obvious danger that improper behavior is reinforced. Many rogue traders have subsequently claimed that their activities were condoned because their superiors also enjoyed the rewards which came with success.

It is rarely the case that a trader starts out by intending to commit fraud. Rarely also is the motivation personal gain, except in the sense that successful trading may bring kudos and a bigger bonus. Rather, a trade at the limit of acceptability may go wrong. Instead of closing out the position and triggering a loss, the trader may try to recoup the loss next day. All goes well until a loss cannot be recovered. Then the trader embarks on the disastrous course of repeatedly doubling up in a desperate attempt to recover the situation, all the while engaging in increasingly elaborate deceptions to disguise his true position.

It is much easier to hide transgressions when a large volume of transactions is taking place against a background of fragmented IT systems and complex processes. Where middle- and back-office responsibility is compartmentalized, no-one may be in a position to see the whole picture. Complex trades can be very difficult to value accurately by anyone other than the front-office expert who is carrying them out. If senior management or supervisors don’t fully understand the nature of products being traded or their inherent risk profile, it is much easier for the rogue trader to disguise the true nature of his position.

It follows from these features that an effective defense needs two mutuallyreinforcing strands: adequate and appropriate controls and the right tone being set from the top. It has been well-said that there are bold traders and old traders, but there are very few old, bold traders. Senior management need to instill a strong culture of respect for controls – which still promote acceptable risk-taking – while explicitly prohibiting the occasional tolerance of breaches. Turning a blind eye from time to time to an unauthorized gamble which pays off risks undermining the whole control framework.

In such a culture, it is then much easier to institute effective systems and controls and to make sure they are respected. Most coverup strategies are comparatively simple. The most obvious course, if closing out a trade is going to crystallize a loss, is to avoid booking it in the first place. So systems need to look for long settlement dates, late bookings, use of suspense accounts, fictitious trades which lack counter-party recognition, cancelled trades, excessive gross versus net exposure and so on. Acceptable profiles for all of these characteristics can be developed, with events outside the established parameters triggering an alarm.

There are also a range of non-technical factors which need to form part of an effective control framework. These range from mandatory training to appropriatelydisciplined controls on access to systems and records. It has been well-publicized in a number of cases that rogue traders have tended to work odd hours, and have been reluctant to take vacations in case their positions were exposed. Profiles for these characteristics should also be established, and divergence flagged up. Correlation between suspicious activities in a number of areas can be especially valuable.

Systems and controls are typically introduced and/or strengthened in the wake of a rogue trading disaster – if the firm has managed to survive it. But the risk of adopting a reactive strategy is clear. By contrast, firms should be adopting a strategy of continual review, stress testing, monitoring and development, to ensure that their defense is as strong as possible.

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